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.


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Is There Any Hope for Emerging Markets?

Emerging US Stocks

Emerging market stocks have been among with worst-performing asset classes this year. While so far in 2015 US stocks are down slightly and international developed stocks are slightly up, emerging market stocks have lost more than 12%. And this isn’t a new phenomenon: in 3 of the previous 5 calendar years emerging market stocks have dramatically underperformed their US counterparts. Is there any hope for this battered asset class?

Part of the problem for emerging markets has been declining economic growth prospects. The International Monetary Fund recently lowered its growth estimates for Latin America and Southeast Asia, and it projects that China’s economic growth rate will continue declining. With emerging economies stagnating while growth rates in developed economies are projected to increase, emerging markets seem like a less compelling investment opportunity.

Another part of emerging markets’ problem has been the US dollar, which has soared in value since the middle of last year. A stronger US dollar directly hurts the value of US investors’ emerging market holdings, which are worth less when converted back into dollars. But it can hurt emerging markets in other ways as well. A strong dollar tends to be associated with lower commodity prices, which hurt the many emerging economies that export commodities. And many emerging markets have debts denominated in US dollars, which are harder to repay when the dollar increases in value.

Given these problems, emerging market stocks may seem like a lost cause. But the flip side of poor performance for an asset class is lower valuations, which can improve the prospects for the asset class going forward. The valuations on emerging market stocks overall are below their historical averages and far below the valuations on US stocks and international developed stocks.

Valuations don’t provide much information about what will happen in the short-term, so it’s certainly possible the emerging markets could continue to underperform for a while. Though below their historical average, emerging market valuations are also still above the nadir they reached in 2008, suggesting that another extreme event (such as China’s recent turmoil turning into a full-blown financial crisis) could lead to further declines. But if they’re able to avoid economic upheaval, emerging markets seem well-positioned to finally end their losing streak.

What the Changes to Your Vanguard EM Fund Mean

China Performance

Vanguard recently announced changes in the investments that some of its funds will hold. Perhaps the most significant of these changes are the ones that affect your Vanguard emerging markets index fund. The fund will add both exposure to smaller companies and exposure to Chinese companies whose shares are listed on stock exchanges in mainland China.

Including smaller companies is a change that Vanguard is making in many of its international funds. The stated reasons for the switch are to make investors’ exposures more in line with the overall market and to increase the diversification of their funds’ investments. These reasons make sense, since when you buy an index fund tracking the performance of a particular market, you generally expect it to track as much of that market as possible.

Stocks of smaller companies tend to be more volatile than stocks of larger companies, and they can also be affected by different economic factors. In emerging markets, for example, companies in the energy, communications, and financials sectors are a much smaller portion of the market among small companies than large ones.

The change to include Chinese stocks listed on stock exchanges in mainland China (often called “A-shares” as opposed to the “H-shares” of Chinese companies listed in Hong Kong) may be even more interesting given what’s happened in Chinese markets recently. As the graph above shows, starting in May the performance of the A-shares dramatically diverged from the H-shares. The A-shares soared until the middle of June and then plunged while the H-shares gradually declined.

Part of the divergence is caused by the companies listed in mainland China often not being the same as the companies listed in Hong Kong. But even A-shares and H-shares of the same company can behave very differently. A-shares have tended to be more volatile than the H-shares, and the disparities have increased in the past year.

According to Morningstar the small company change and the China change will combined affect only about 15% of Vanguard’s emerging markets fund, so they shouldn’t substantially alter the fund’s performance. Most of the fund will still be invested in larger companies, and Chinese companies listed in Hong Kong will still be a much larger portion of the fund than Chinese companies listed in mainland China. The only difference investors may notice is that by the time Vanguard finishes implementing the changes (which will be sometime next year), the fund will be slightly more diversified and possibly slightly more volatile.

How a Strong US Dollar Can Hurt Emerging Markets

Strong Dollar

The US Dollar has surged in 2014, increasing in value since the start of the year versus every other major currency. A strong US dollar has big implications for the global economy and affects almost every investment in your portfolio. Not all of these effects are the same, however, and the most substantial impact may be on investments in emerging markets.

The most straightforward effect from a stronger US dollar is a decline in the value of international holdings for US investors. This is simply math: when the values of the investments in foreign currencies are converted back to US dollars, they’re worth less than they previously had been.

For some foreign companies part of this decline may be offset because a stronger dollar means that their exports become more affordable. But overall these direct effects of a stronger dollar tend to hurt emerging market investments. Both emerging market stocks and local-currency emerging market bonds have returned about -5% so far this year.

A stronger dollar has other effects as well. It tends to be associated with lower prices for commodities such as oil (there are a number of reasons for this association, with both a stronger dollar contributing to a lower oil price and a lower oil price contributing to a stronger dollar). The oil price has indeed plunged this year, particularly hurting oil-producing countries such as Russia, Venezuela, and a number of countries in the Middle East. With declining oil revenues and a tanking currency, Russia appears to be on the verge of a financial crisis that could wreak havoc on its economy.

There could be additional emerging market victims if the US dollar continues to gain strength. Many emerging markets have debts denominated in dollars, and a stronger dollar makes these debts harder to repay. Given their external debts and their proximity (both geographically and economically) to Russia, a number of other Eastern European countries may be vulnerable.

The Rise of Political Risk

One important trend in global financial markets during the last few years has been a rise in political risk, a concept referring to political changes that could affect the value of an investment. The number of events associated with political risk—such as elections, mass protests, and military interventions—has increased by 54% since 2011, according to a study by analysts at Citigroup. This kind of increase has a couple key implications for investors.

The first is that it can affect the relative performance of emerging markets versus developed markets. Interestingly, while political risk has historically been most closely associated with poorer countries, in recent years it has appeared in some of the wealthier emerging markets and even developed ones.

In emerging markets there have been protests in a wide range of countries, including Brazil, Russia, South Africa, Thailand, and Turkey. In developed markets, political posturing opened up the possibility that the United States government would default on its debt in the summer of 2011, and extremist parties opposed to the European Union did well in recent elections for the European Parliament.

A continued increase in political risk would likely hurt emerging markets more than developed markets, even if the risks aren’t isolated to emerging markets themselves. Investment typically flows from emerging markets into “safer” markets (such as the United States, Switzerland, and Japan) when perceived risk increases. This shift can take place even when the risk originates in the developed countries, as was the case when emerging markets were pummeled during the 2008 financial crisis.

A second implication of increased political risk is that it may lead to more divergence in the performance of stocks in different countries. This trend is already evident in some of the countries that have recently experienced notable political events. For example, Russian stocks have lost 8% so far this year (and at one point were down close to 25%) as the country became involved in territorial battles with Ukraine. Indian stocks, by contrast, have risen more than 20% this year as political power shifted in the country’s May elections.

EM 2014 Performance