The numbers don’t lie — emerging equity markets (EMs) have dramatically lagged US equities in 2018 as shown in the table below. The chaos in EM is best exemplified by the Brazilian elections, Russian sanctions, deleveraging in China, and the South African land redistribution policy. However, in some cases, factor-based approaches fared better than the overall market in EM, and I believe there are three indicators suggesting it may be time to reconsider this asset class.
Signs of EM life
Year to date, the MSCI Emerging Market Index has fallen 7.40%. That was surpassed by the Low Volatility factor (the S&P BMI Emerging Market Low Volatility Index rose 1.70%) as well as the fundamentally weighted FTSE RAFI Emerging Markets Index, which was down 2.59%. The Momentum factor turned in mixed results in EM — the S&P Momentum Emerging Plus Large Mid Cap Index was down 7.13%, slightly outpacing the MSCI Emerging Market Index, while the Dorsey Wright Emerging Markets Technical Leaders Index contracted 9.91%. In my opinion, factor-based strategies represent alternatives to a market cap methodology with the potential to add value to an EM portfolio.
Outside of factor strategies, the 20% rally in the technology heavy NASDAQ-100 Index and the 20% decline in the Alphashares China Technology Index is eye-catching in terms of highlighting the difference in EM and US equity market performance this year.
Select index returns highlight the underperformance of EM stocks versus US
Source Bloomberg, L.P. as of Sept. 30, 2018. Past performance is not a guarantee of future results. An investment cannot be made directly into an index.
Three reasons to look at EM
I see three reasons why emerging markets may find support in the coming months.
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The case for US stocks may look less compelling in 2019. US small caps have been firing on all cylinders until very recently, supported by the favorable impact of the 2017 tax cuts, the relative strength of the US economy, trade war uncertainties and economic chaos in EMs. Through the end of the third quarter, the S&P Small Cap 600 Index had rallied 14.54%. But going into 2019, US small cap earnings may have trouble keeping up with their performance this year, creating a headwind to their return profile. Moreover, the ongoing impact of Federal Reserve tightening and the fading effects of the tax cut may slow profit growth. I believe the small-cap sector is unlikely to outperform like in 2018, and that emerging markets may start to look better by comparison.
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Trade clouds may be breaking up. The trade picture may be beginning to clear. A new trade agreement between the US, Canada and Mexico has been struck, and the outcome of the US mid-term elections could shed more light on the willingness of China and the US to make a deal. China seems to be hoping President Donald Trump loses political momentum. If Republicans hold onto their strength in Congress after the mid-terms, that may push China toward a deal. But if Republicans suffer election losses, that may create more US willingness to deal with China. In any case, the November elections could be a pivot point, especially with the recent deal in North America. An improved trade outlook may benefit emerging market economies and foster more risk-taking.
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Emerging market dysfunction is well-known. The MSCI Emerging Markets Index has declined about 25% this year from the Jan. 29 high to the Oct. 11 low. The bearish picture is well-priced in these markets, but there are potential positives on the horizon. China is working to reflate its economy — although success is uncertain, the credit contraction is stabilizing and tax cuts are being implemented. The Brazilian election will eventually be out of the way (the second round occurs Oct. 28), and it may result in some policy clarification by year-end. In Russia, any investors who fear the potential impact of sanctions have likely left the Russian equity market already, and the firm tone of oil has bolstered the growth picture for the Russian economy.
Possible signs of a bottom?
Picking a bottom is a risky game, but the MSCI Emerging Markets Index recently found support at the 950 level. Likewise, the Chinese Shanghai Shenzhen CSI 300 Index is approaching psychological support at 3,000 after tumbling nearly 30% from its January 2018 high. The recent Bank America Merrill Lynch Fund Managers survey indicated that respondents had lost their appetite for emerging markets. Both current positioning and intentions for the next 12 months were said to have turned negative or neutral.[1] This may be a sign that the emerging markets are poised for a comeback.
Those interested in emerging market investing can explore Invesco’s emerging markets EM line up by clicking here: https://www.invesco.com/portal/site/us/investors/etfs/.
1 Source: Bank of America Merrill Lynch, “BofA Merrill Lynch Fund Manager Survey,” Aug. 2018
Important information
Blog header image: AsiaTravel/Shutterstock.com
The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries.
The S&P BMI Emerging Markets Low Volatility Index measures the performance of the 200 least volatile emerging market stocks. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile emerging market stocks receiving the highest weights.
The FTSE RAFI Emerging Markets Index is designed to track the performance of the largest emerging market equities, selected based on the following four fundamental measures of firm size: book value, cash flow, sales and dividends.
The S&P Momentum Emerging Plus LargeMidCap Index is designed to measure the performance of securities in emerging markets plus Korea that exhibit persistence in their relative performance.
The Dorsey Wright Emerging Markets Technical Leaders Index includes approximately 100 companies that possess powerful relative strength characteristics and are domiciled in emerging market countries including, but not limited to Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
The Nasdaq-100 Total Return Index includes 100 of the largest domestic and international non-financial securities listed on the NASDAQ Stock Market based on market capitalization. An investment cannot be made into an index.
The Alphashares China Technology Total Return Index measures and monitors the performance of an investable universe of publicly-traded Chinese companies.
The S&P SmallCap 600® Index is a market-value weighted index that consists of 600 small-cap US stocks chosen for market size, liquidity and industry group representation.
The S&P 500® Total Return Index is an unmanaged index considered representative of the US stock market.
The S&P MidCap 400® Total Return Index is an unmanaged index considered representative of mid-sized US companies.
The BNY Mellon BRIC Select DR Total Return Index tracks all Depositary Receipts traded on the NYSE, NYSE American, NASDAQ, LSE and local shares traded on the Hong Kong Stock Exchange, that represent shares in companies meeting a minimum market capitalization and U.S. dollar trading volume from Brazil, China, India and Russia. This index is calculated on a continuous basis throughout the trading day and is market capitalization-weighted and adjusted for free float utilizing S&P Dow Jones Indices methodology.
The S&P Momentum Emerging Plus LargeMidCap Index is designed to measure the performance of securities in emerging markets plus Korea that exhibit persistence in their relative performance.
The Invesco China Real Estate ETF is based on the AlphaShares China Real Estate Index. The Fund will invest at least 90% of its total assets in securities that comprise the Index and American depositary receipts (ADRs), American depositary shares (ADSs), global depositary receipts (GDRs) and international depositary receipts (IDRs) based on securities in the Index.
The FTSE Emerging Markets All Cap China A Inclusion Index comprises the Large, Mid and Small Cap constituents of the FTSE Global China A Inclusion Index.
The MSCI Emerging Markets Equal Country Weighted Index captures large and mid-cap representation across 24 EM countries. The Index includes the same constituents as the MSCI Emerging Market Index but applies an equal country weighting at each semi-annual index review date.
The NASDAQ Golden Dragon China Total Return Index is a modified market capitalization weighted index comprised of companies whose common stock is publicly traded in the United States and the majority of whose business is conducted within the People’s Republic of China.
The Shanghai Shenzhen CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of top 300 stocks traded in the Shanghai and Shenzhen stock exchanges.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes. Factor-based strategies make use of rewarded risk factors in an attempt to outperform market-cap-weighted indexes, reduce portfolio risk, or both.
Diversification does not ensure a profit or eliminate the risk of loss.
Low volatility cannot be guaranteed.
Momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
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