Outlook for Emerging Markets

2018 was a year of choppy returns in the global markets, and especially so in emerging market (EM) equities. Although emerging market equities tend to exhibit more volatility than other asset classes, we believe they are an important element of a diversified portfolio, as does Tim Atwill, PhD., CFA, Head of Investment Strategy at Parametric, a trusted sub-advisor for Madison.  In the commentary below, Tim and team layout the optimistic case for having an EM equity allocation in portfolios.

“Without qualification 2018 was a bad year for emerging market (EM) equities. We saw currencies get devalued across the board, with full-blown crises in Turkey and Argentina. The underlying equity returns weren’t much better, with the leaders of 2017 (China and Korea) turning into the laggards of 2018, thanks to the growing impact of the US-China trade war paired with a global sell-off in technology and semiconductor stocks, which had led the way in 2017.

Indeed, for many the New Year couldn’t come soon enough. So what’s the outlook for EM stocks in 2019? Call me a Pollyanna, but while the potential exists for continued bumpiness, let me make the optimist’s case for emerging markets in 2019.

EM Stocks are Cheap

Valuations are ultimately what drives long-term returns, and the most fundamental advice (buy low, sell high) can be reinterpreted as “buy what’s cheap, sell what’s dear.” Looking at cyclically adjusted P/E ratios (CAPE), we can see that EM stocks, as is traditionally the case given their higher risk, are much cheaper than developed-market and US stocks. However, the size of the discount is notable:

Source: Parametric, MSCI, as of 12/31/2018

Not only is the gap between EM and the other categories much greater now than it’s been over the past 10 years (8%–11%, versus the 4%–6% differential seen in the 10-year figures), but EM is the only asset class of the three trading cheaper than its 10-year average. Both of these indicate that the price reductions in 2018 have set the stage for a higher probability of future success for EM investors.

The US Dollar is Likely to Weaken

Over the past year the dollar has enjoyed a strengthening cycle versus most EM currencies. For the US-based investor, this caused a significant haircut to 2018 returns, since negative returns in foreign assets were further diminished by the reduction in these values when restated in dollar terms.

The below graph compares the returns of the MSCI EM Index when stated in dollar terms, with these same returns stated in local terms. This latter index captures the underlying equity-market returns—but ignores the impact from currency—and is equivalent to the returns one would experience if the currency exposures were completely hedged at no cost. As we can see, the impact from dollar strengthening wasn’t insignificant:

Source: Parametric, MSCI, as of 12/31/2018

However, several drivers of dollar strengthening are set to diminish over 2019. The Fed, whose rate increases have made US assets among the highest yielding in the world, has expressed a much more dovish tone about its intentions in 2019. In addition, Treasury-bond auctions continued to encounter difficulties clearing the market in November, thanks to the size of the offerings and growing concerns over the increasing US fiscal deficit. Both of these indicate that the dollar may be coming to the end of its strengthening cycle and that a mammoth headwind to EM assets could instead turn into a tailwind.

The Fed has Ended its Tightening Cycle

Market folklore holds that EM assets do poorly during a Fed tightening cycle as US investors move money from high-yielding (but risky) EM assets to safer (and now competitive) domestic investments. While the Fed has cast doubt on this phenomenon, it certainly appears to have been a contributor to last year’s decline in EM assets.

Source: US Federal Reserve, as of 1/10/2019

With the Fed expressing an increasingly dovish tone regarding its actions in 2019, this dynamic should be less pronounced. More important, those EM economies that weathered this bout of tightening have done so with remarkable fortitude, tightening rates at a similar pace as the Fed has or, at the very least, not experiencing debt blowups like the EM nations of yore. This speaks to a more solid economic foundation among developing countries that may finally be recognized now that the tightening cycle is nearing its end. In addition, should the Fed pause entirely in 2019, it would allow EM countries’ central banks to lower rates, which could help stimulate their economies just as the US growth story potentially comes to an end.

The Bottom Line

The past year has wrung out the EM asset class, making current valuations extremely attractive on a historical basis—and especially versus US and developed-market equities. However, where exactly the growth will occur is hard to say. Historically, smaller countries have done no worse than larger countries. And given the elevated risks around a continuing trade war with China, we continue to believe diversification at the country level is the best way to ensure an investor can capture any rebound in the asset class in 2019.”

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written. Actual economic or market events may turn out differently than as presented. © 2019 Madison Wealth Management