To be sure, these are market trends driven by reactionary investor
behavior. Changing EM fundamentals cannot be blamed. What is now clear is
that the U.S. is currently the mercurial radical egging global financial
markets and economies.
Yet, the U.S.’s enthusiasm for trade brinksmanship will almost certainly be
self-defeating, akin to the proverbial boiling frog. The damage to their
own economy will be gradual… naware they are being boiled until it’s too
Increasing risks in the U.S.
Why? At the risk of stating the obvious, much of American business operates
globally. U.S. companies have built up massive manufacturing bases overseas
(iPhones anyone?). Host countries could easily retaliate and make the
business environment much less hospitable. What’s more, countries outside
the U.S. could shift their import demand. The tariffs that come into effect
in July will undoubtedly impact EMs via their integration into China’s
supply chains. Over the long run, however, EMs will very likely see a
redistributive effect whereby China shifts its import demand away from the
U.S. and toward other EMs.
Most importantly, Trump has taken a wrecking ball to the U.S.-led post-war
world order and America’s longstanding alliances (including immediate
neighbors, Canada and Mexico). By slapping tariffs on the U.S.’s closest
allies, Trump is practically chasing them into China’s arms. But there is a
longer and more critical strategic reorientation at play: By withdrawing as
the world’s leading country, the U.S. effectively allows for the emergence
and even acceleration of new powers.
Chinese President Xi Jinping, who has worked steadily over the past four
years to strengthen China’s position in Asia, likely views Trump’s retreat
from globalization as his own triumph. Consider former President Obama’s
“pivot to Asia,” with the Trans-Pacific Partnership being the centerpiece.
It is now dead. That leaves Xi’s “Belt-and-Road” strategy (his own version
of “Make China Great Again”) as the uncontested blueprint for future
economic integration in Asia.
What about U.S. markets? Here, the basic fundamentals of the U.S. markets
could not be less attractive. Its equity market is extremely expensive
relative to the rest of the world; the U.S. dollar is overvalued; its
fiscal policy entirely inappropriate; and its tightening monetary policy
prone to triggering high interest-rate sensitivity.
EM fundamentals solid
Given Trump’s extreme bluster and incivility, it is remarkable how
restrained the setback has been in EM overall. Using the
iShares MSCI Emerging Markets Index ETF (NYSEArca: EEM) as a proxy, consider these comparatives. To date, since an intermediate top
set at the beginning of 2018, EEM has declined 17%. In the second half of
2015, by contrast, EEM declined 36% (that was more than twice the decline
of EEM during the first half of 2018).
What was called the “taper tantrum” in 2015 was hardly the global rumpus
spectacle of rabid populists that we see today. Therefore, seen relatively,
the instabilities in EEM markets this year have been modest. That is a
Most media attention has focused on the woes of Argentina and Turkey. But
every year, some EM or frontier country will experience serious
macroeconomic instability. Why superimpose the experience of a few
idiosyncratic basket cases on an entire universe of more than 75 countries
(many of which have solid fundamentals)?
The overall EM position is far more benign than a few outliers. Economies
are much more shock-resistant than previously, owing to a whole host of
improving macroeconomic factors. For example, in the mid-1990s inflation
rates above 20% were not uncommon. Today’s EM inflation is trending below
4%. The list of improving factors is lengthy: the emergence of domestic
pension systems (which reduces reliance on foreign funding); improved trade
balances; better fiscal positions; and a number of other strong secular
What about valuations? Here, more good news exists. EM stocks trade at a
hefty discount to their developed-market peers (based on price/forward
earnings). EM debt presents good value, offering higher yields than the
U.S. high yield space with arguably less risk. And EM currencies can only
be described as a “deep value” play. Remarkably, EM nominal exchange rates
are today roughly 40% lower than during the 2008 global financial crisis.
Where to next? History shows that EM outperformance cycles typically unfold
over several years. The last eight years of EM underperformance (for the
period ending in 2016) were preceded by nearly nine years of
outperformance. Furthermore, EMs already had a large slowdown between 2010
and 2016. Since then, currencies have weakened (boosting competitiveness),
and policy has turned stimulative (lowering the cost of capital). These
benefits always show up with a lag. Why should this time be different?
Investors shouldn’t be swayed by short-term market moves and must maintain
longer-term perspective (a repeated point we make with clients). A quarter
or two of underperformance or market downtrend neither offers a valid
decision pivot point nor indication of long-term performance. Our 15-year
track record proves that.
Emerging markets, as an asset class, are volatile by definition. During the
last seven years, there have been five other reversals of EEM (six in
total, nearly one per year) of greater magnitude than experienced year to
date. In every case, there were subsequent recoveries…some carrying to new
Any long-term commitment to emerging market equities will face blustery
retracements and corrections. However, we believe that the higher long-term
returns are worthwhile – especially so seen in the context of a balanced
The proximate causes of the recent EEM downdraft are these three macro
pricing factors: 1) rising U.S. interest rates; 2) rising oil prices; and
3) a strong U.S. dollar.
We think that several – or all – of these will soon bring some sinecure and
relief. The U.S. dollar may now be peaking, more certainly so against the
euro. Secondly, intermediate-term U.S. interest rates have shown a
moderating trend recently. And, what about the price of oil? It remains
prone to a decline…but remains near recent highs. We therefore theorize
that much of the EM slide is over. EM outperformance should resume soon. We
are only in the foothills of a longer-running period of outperformance.
Tyler Mordy, CFA, is President and CIO for
Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities
selection. He specializes in global investment strategy and ETF trends.
This article first appeared in Forstrong’s
Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong
Global, toll-free 1-888-419-6715, or by email firstname.lastname@example.org. Follow Tyler on Twitter at @TylerMordy
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