Yahoo Finance Emerging Markets 'Crisis' Provides Opportunity For Investors
For the better part of a year, investors have been reading about a "crisis" in emerging markets. By now you're likely familiar with the myriad of headlines that include buzzwords such as "higher inflation," "slower growth," "political turmoil," "rising interest rates" and "currency depreciation."
We saw a spike in these negative headlines near the lows in early February of this year. Although there is always some element of truth in these fear-inducing headlines, the question for investors is, "What should I do about them?"
For most investors, doing nothing should be the default option, as any response to the news is likely to do more harm to their portfolios than good. As an investor, you need to separate the news from the markets. The news is reporting what has happened in the past while the markets are forward-looking. By the time the major news media is focusing on a "crisis," it is often a time of opportunity as investors have already priced-in all of the negative news. Therefore, reacting to the negative news by selling can be extremely detrimental to investor returns.
As I have been writing about all year, for investor should be willing to go against the crowd. Emerging markets currently represent one of the few opportunities within the equity markets to improve long-term returns. There are a number of factors supporting this view:
Valuation. By any widely observed valuation metric, Emerging markets are cheap on both an absolute and a relative basis. On a price-to-book basis, Emerging market equities are trading well below their historical averages and near trough levels last seen in early 2009. On a relative basis, emerging markets are trading at cyclically adjusted P/E ratios of roughly half of the U.S. Although it is not a short-term predictor of returns, there is no better predictor of long-term returns than beginning valuation.
Sentiment. Sentiment can be an important driver of returns, particularly at turning points. As emerging markets have been underperforming U.S. markets for over three years, there is no more hated asset class in the world today than emerging markets. Entering April, investors had already pulled out $35 billion from emerging market equities, more than doubling last year's outflow. In a recent Bank of America-Merrill Lynch Survey, asset allocators reported a record underweight to emerging markets. Looking ahead, this type of extreme hatred for an asset class often leads to outperformance.
Relative performance. Over the past three years, the Russell 2000 index is up over 45 percent, while the MSCI Emerging Markets index is down over 12 percent. This is an extremely wide spread on a historical basis. Studies have shown that at the three-year mark, you tend to see mean reversion among asset classes, and we are starting to see this over the past month. While U.S. small-caps have declined over 5 percent in the past month, emerging market equities have advanced over 5 percent. Given the wide spread that still persists between the two asset classes, we are likely still in the early stages of emerging market outperformance.
Poor economic data. This may seem counterintuitive, but there is often an inverse relationship between gross domestic product growth and forward returns. Reports that emerging market growth is slowing should be a welcoming sign for new investors as the markets have already priced in this poor data. Therefore, any improvement in the data going forward will be a positive surprise and likely a catalyst to drive share prices higher.
Monetary policy. While the U.S. is currently winding down its quantitative easing program and hinting at raising rates next year, emerging markets have already taken their medicine. A number of countries (India, Brazil, South Africa, Turkey, etc.) have already raised interest rates to curb rising inflation and stabilize their currencies. This action leaves room for central bankers to loosen monetary policy in the coming years, which in turn would be an additional catalyst for equity prices.
Credit. Although the media continues to write of an emerging market "crisis," the "smart money" credit markets are not confirming this view. Rather than deteriorating, credit markets continue to improve. In fact, emerging market credit is actually outperforming U.S. high-yield credit this year. As credit typically leads, this should bode well for equities in the coming months and years.
Bottom line. When it comes to investing, there is hardly a worse strategy than reacting emotionally to negative news flow. Investors would be wise to ignore the continued negative news in emerging markets, and at the margin, use it as an opportunity to increase their exposure to the asset class. Those who have already sold out of emerging markets this year in reaction to the recent news may want to rethink that strategy.
Charlie Bilello is the director of research at Pension Partners, LLC. He is responsible for strategy development, investment research and communicating the firm's investment themes. Prior to joining Pension Partners, he was the managing member of Momentum Global Advisors. Bilello holds a Juris Doctor and Master of Business Administration in finance and accounting from Fordham University and a bachelor's in economics from Binghamton University. He is a chartered market technician and holds the certified public accountant certificate.
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