Emerging Markets’ Lost (Near) Decade

Turkey Skyline

U.S. technology is once again ascendant. Since the fall of 2016, the S&P 500 Technology Sector Index is up nearly 70%; the tech sector now accounts for more than 25% of the S&P 500 market capitalization.

Despite the strength of the recent rally, tech enthusiasts will recall a long, long period of unpopularity. After peaking in early 2000, the tech sector lost more than 80% of its value. It then took 17 years until the sector reclaimed its 2000 peak.

Investors in emerging market (EM) stocks should keep that history in mind as they go through a similar, albeit less prolonged drought. The MSCI Emerging Markets Index is trading at approximately the same level as it did in early 2010.

Value, or the lack thereof, played a part

Valuations in emerging markets never approached the Olympian heights that tech stocks traded at in the late 1990s.  That said, valuations have played a part in emerging markets’ struggles.

Since coming out of their own financial crisis in late 1990s, emerging market stocks have tended to trade in a well-defined range versus developed markets: a 45% discount to a 10% premium (based on price-to-book). Periods when EM stocks traded at a premium, such as late 2007 and 2010, turned out to be market tops. Interestingly, EM’s recent 20% drop was not proceeded by egregious valuations. In January, EM stocks were trading at approximately 1.9 times x book, a 23% discount to the MSCI World Index.

Another bottom?

Following the recent correction, EM stocks are trading at levels that preceded previous rebounds. EM equities are trading at roughly 1.55 times price-to-book (P/B), the lowest since late 2016 and a 35% discount to developed markets. Price-to-earnings (P/E) measures paint a similar picture. Current valuations represent a 33% discount to developed markets. Today, countries from Russia to South Korea are trading at less than 10x earnings.

Country Equity Valuations

Of course, valuations are never the complete story. In the short term, they might not even be that relevant. As I discussed back in August, an EM rebound probably requires two other components: a flat-to-cheaper dollar and signs of an economic rebound. On the former, emerging markets should be getting some relief as the dollar is now down nearly 3% from its August peak.

In terms of economic growth, the picture is more mixed. In late July it briefly looked like emerging market economies were growing faster than expectations. That rebound proved fleeting. Going forward, investors should focus on China, where efforts to accelerate the economy through monetary stimulus are accelerating. Typically, these efforts start to impact the real economy with a 1-2 quarter lag.

Continuing pressure on particular EM countries–notably Turkey and Argentina–are partially responsible for recent losses. Escalating trade frictions have not helped. Still, should the dollar remain stable and China begin to accelerate, valuations suggest the potential for a sizeable rebound.

Bottom Line

For investors who have given up on emerging markets, it may be worth recalling that nine years after peaking, U.S. technology stocks were still down nearly 80%. From there the sector began a rally that has lasted more than nine years and resulted in a gain of more than 500%.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. 

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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More Myth Debunking

Federal Reserve Building

In a previous SMC FIM commentary, we attempted to debunk the “market timing” myth and presented evidence that showed investors actually lose valuable tax-exempt income by not maintaining a fully invested bond posture. This month we challenge the veracity of another widely held market myth:

“Fed short-term interest rate tightening results in equivalent higher long-term interest rates”

 Many investors mistakenly assume that short-term and long-term interest rate movements are linked through comparable yield movements. However, history disproves this notion.

  • During the last extended period of Fed rate tightening (2004-2006), the Federal Funds rate increased by 425 basis points; however, the 10-year U.S. Treasury yield experienced an increase of only 50 basis points.
  • During this time period, municipal bond yields, as measured by the Bond Buyer 20-Bond Municipal Bond Index, actually declined by 27 basis points. Historically, the movement in tax-exempt bond yields generally fails to match that of Treasury or comparable corporate securities.

We believe there is a good chance that history will repeat itself during the current phase of short-term rate increases. Why?

  • First, think about what long-term interest rates reflect: the expectation of future short-term rates plus a risk premium – the extra compensation for owning a security that will not pay off until sometime in the future. Investors should be paid for market uncertainty. Investing in U.S. Treasury securities does not present any credit risk, so the major risk factor is inflation.
  • As reflected by current bond interest rates, the threat of inflation continues to be constrained. Lack of significant inflation pressure should continue to subdue any meaningful rise in intermediate-term and long-term bond yields, even as short-term interest rates are managed higher by the Fed.
  • The goal under the current Fed program is to normalize interest rates and not to stem an imminent inflation threat. Today’s program is without historical precedent. So, the impact on long-term interest rates this time could be even more muted than what has happened in the past, causing a further flattening of the yield curve.
  • The impact within the municipal market is already being reflected in a flatter yield curve. We believe this is due in part to the significant reduction in net new tax-exempt bond issuance and an increase in retail demand due to changes to the individual income tax code such as the elimination of greater than $10,000 of SALT deductibility.

 

SMC Fixed Income Management (SMC FIM) is a municipal bond advisor and manager that provides customized municipal portfolios for individuals, trusts and estates through its Separately Managed Account Program, and provides advisory services to Unit Investment Trusts.

 

Disclosures

The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management (“SMC FIM”), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.

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