Emerging markets are flashing warning signs, but don’t tell that to value stocks.
The MSCI Emerging Markets Index is down 19.2 percent from its recent high on Jan. 26 through Friday as investors wring their hands over tariffs, slow growth, a rising dollar and numerous other fears.
To some investors’ surprise, value stocks are holding up better than growth. The MSCI Emerging Markets Value Index is down 18.3 percent, while the MSCI Emerging Markets Growth Index is down 20.1 percent.
In theory, that’s not supposed to happen. Value stocks, after all, are cheaper than growth for a reason: They represent companies, and sometimes whole sectors, that have fallen on hard times or are struggling to grow — think banks and brick-and-mortar retailers. Those problems are compounded in a downturn. And as goes the business, so goes the stock.
But in reality, stocks haven’t always followed that playbook, at least in the U.S. I counted 13 U.S. bear markets since 1926, as defined by a decline of 20 percent or more in the S&P 500 Index for the longest period for which numbers are available. I’m also counting the periods from September 1929 to March 1935 and from March 1937 to April 1942 as a total of two bear markets.
Imagine you hadn’t read the headlines about emerging markets this week. You didn’t know that South Africa slipped into a recession, or that the currencies of Turkey, Argentina and Indonesia are near record lows, or that seemingly every emerging-market analyst predicts that the trouble will spread to other developing countries.
Instead, all you would have are the numbers showing how emerging-market stocks have behaved in the past. You would see that the MSCI Emerging Markets Index returned 8 percent annually in dollars since 1988 through August, excluding dividends, and that the volatility, as measured by annualized standard deviation, was 23 percent during the period.
You would quickly deduce that emerging-market stocks are a wild ride. The EM index can be expected to decline more than 40 percent of the time and enter bear market territory — a decline of 20 percent or more — close to a third of the time. You would then notice that the EM index has fallen by 19.7 percent in dollars from its peak on Jan. 26 through Wednesday and most likely conclude that nothing unusual was happening.
Here’s a brainteaser: While investors fret about trade wars and rate hikes, U.S. stock prices keep climbing.
Answer: Investors are indeed running for the exit — just through the wrong door.
Emerging-market stocks, not those in the U.S., are taking the brunt of investors’ fears. The MSCI Emerging Markets Index is down 7.7 percent this year through Wednesday, while the S&P 500 Index is up 5.3 percent. The EM index is also down 16 percent from its high on Jan. 26, just shy of the 20 percent decline that signals a bear market.
There’s a reason to worry about emerging-market currencies, but not the one investors have in mind.
Some developing countries are stumbling, and their currencies aren’t taking it well. Turkey’s lira is down 16 percent against the dollar since its peak on Feb. 1 through Wednesday, and Brazil’s real is also down 16 percent since Jan. 24.
The declines have recently spread to other EM currencies. The MSCI Emerging Markets Currency Index — a basket of currencies that tracks the country allocations in the MSCI Emerging Markets Index — is down 3.5 percent since its peak on April 3 through Wednesday.
No, it’s not 2008 for emerging markets — at least not in the way investors fear.
Harvard economist Carmen Reinhart stoked investors’ anxiety last week, saying that emerging markets are in worse shape now than during the 2008 financial crisis. Among Reinhart’s long list of concerns are a stronger dollar, mounting debt and various and sundry problems in Brazil, Chile, Argentina, Turkey, sub-Saharan Africa and the Middle East.
In response, Bloomberg News looked at a group of developing countries and found that they are, in fact, worse off now than during the financial crisis in some important ways. The group, for example, has a modest current-account deficit, whereas it boasted a big surplus in 2008. The countries’ economic growth is also lower than it was during the crisis, and their government debt-to-GDP ratio is higher.
It all sounds worrisome, but the relevance of Reinhart’s concerns to investors is questionable. For starters, most investors dabble in emerging markets through mutual funds and exchange-traded funds, and most of those investments are in stocks. There’s $588 billion invested in emerging-market stock funds and $92 billion in bond funds, according to Morningstar data.
Those stock funds have nominal exposure — or none at all — to the countries that Reinhart is concerned about. The biggest emerging-market stock fund is the Vanguard FTSE Emerging Markets ETF, with $66 billion in assets. Sixty percent of the fund is invested in China, Taiwan and India. Its combined exposure to South America, Turkey and the Middle East is just 13 percent, and 8 percent of that is in Brazil. (Disclosure: I own Vanguard funds and my asset-management firm buys them for investors.)
China’s parliament begins a two-week legislative session on Monday that is widely expected to clear the way for Xi Jinping to be president for life. As concerned emerging-market investors question what will happen in China, they should remember one thing: China isn’t synonymous with emerging markets.
Investors can be forgiven for conflating the two. Many of them see the developing world through the lens of an emerging-market stock fund, and Chinese companies increasingly dominate those funds.
Consider, for example, that China accounts for 27 percent of the MSCI Emerging Markets Index. That’s 13 percentage points more than South Korea, the second-largest allocation in the index. It’s also 18 percentage points more than China’s slice of the index a decade ago, when it was fifth behind Brazil, South Korea, Taiwan and Russia.
There are reasons to be skeptical about high-yield bonds, but not for the ones investors have been worried about lately.
For starters, there’s little indication that investors are fleeing risky bonds for good. Yes, two of the biggest U.S. junk-bond ETFs have experienced outflows this month. Investors pulled $1 billion from the SPDR Bloomberg Barclays High Yield Bond ETF through Friday and $600 million from the iShares iBoxx High Yield Corporate Bond ETF.
But there’s nothing unusual about those outflows. The SPDR ETF experienced outflows in 30 of the 71 months since 2012, and the iShares ETF experienced outflows in 33 of those months. Both funds have also had bigger monthly outflows since 2012 than they’ve had so far in November. None of those occasions appear to have dimmed investors’ fondness for junk bonds. In fact, there are indications that money is already flowing back in.
Martin Taylor of Nevsky Capital said goodbye to investors last month in a letter that, as my Bloomberg colleague Mark Gilbert noted, signaled that Taylor may have “lost his appetite for the daily fight to outsmart the market.”
Despite racking up a return for his investors of more than 6,400 percent between 1995 and 2015, Taylor said he decided to hang up his cleats as an emerging markets manager of Nevsky and its predecessor because “what we have done has worked brilliantly for twenty years but does not work any more.”
With China in the midst of what appears to be a significant economic slowdown, investors are questioning their faith in one of the new century’s great growth stories. They shouldn’t abandon China just yet.
First, some perspective. China was never going to string together an uninterrupted record of astounding annual growth. Despite all the hyperbole in recent years about China’s prowess and coming global dominance, not even China is exempt from the business cycle. But the current contraction will be followed by another expansion, unless you believe that China is going out of business — and no one who is a serious student of the country and its economy believes that.
Everyone has grown accustomed to thinking about emerging markets as a monolith — a collection of undifferentiated countries aspiring to the big leagues, with all of the heft and stability of more developed economies.
Emerging markets share similar traits, oftentimes the market prices them similarly, and so they all get wrapped into the familiar and popular one-size-fits-all basket called THE EMERGING MARKET FUND.
Today, that’s the wrong way to think about emerging markets.