EMERGING MARKETS PUZZLE

Transcription

1 MARCH 2016 EMERGING MARKETS PUZZLE The collapse in many commodity prices following the economic slowdown in China and Saudi Arabia s oil production policies has hit many emerging market economies like a tsunami. In many cases there was no high ground to run to. In Chart #1 below of the S&P 500 Index performance compared to the Emerging Market Index we see the big divergence beginning in Coming out of the 2009 market bottom, Ledyard had used selected emerging market country funds that had declined severely in to gain exposure to a rebound we hoped would happen given a massive credit expansion and capital spending boom in China. Back then people spoke of the BRICS (Brazil, Russia, India, and China). We purchased country index funds for Brazil, China, India and Taiwan. This exposure and the performance of the general emerging market economies were very robust until 2011 when European sovereign debt worries brought a market contraction. We did not understand then what we know now about what was happening to the internal imbalances building in the Chinese economy. Our positions started to weaken and we received sell signals from our technical momentum indicators, basically letting the market tell us when to sell. This proved fortuitous as a slowing China created a black hole in the global demand for many of the commodities that had heretofore provided enormous stimulus to countries who sold to China. We have not had direct emerging market exposure since. We now want to take a fresh look.

2 Chart #1: long view of Emerging markets compared to S&P 500 First of all, our experience tells us that within the developing markets, picking the right country exposure is more important than a particular sector within their economy. This feels like common sense as in developing economies there are likely more macro issues and unique business cycle volatility influences than for Developed Western economies. As a metaphor, it is more important that one chooses a boat that does not capsize than to worry about what the boat is carrying. A clear example would be Russia, almost solely reliant on oil and gas, as compared to the Philippines or Vietnam. We see today that retail investors are climbing back into undifferentiated index funds such as ishares MSCI Emerging Market Index (EEM) and that YTD, this fund is bettering the S&P 500 with a gain of 3.6% vs. 0.14%. Chart #2 illustrates the relative returns. However, if one picks a single country exposure we think one can do better by de selecting big losers like Russia and Brazil. By example, Chart #3 offers a view of Chile where the outperformance is much greater than the broad index. Having been in Chile recently, I would sooner bet on the persistence of their recovery than on Brazil, Russia, and Mexico etc. 2

3 Chart #2: Emerging Market index compared to S&P 500 YTD 2016 Chart #3: Chile compared to E.M. Index 3

4 In a country like the US, the sectors are more important where consumer, healthcare, and technology are positive compared to negative sectors like energy and industrials. We are feeling the pain indirectly from emerging market weakness as we try to export to them at a time when our currency is expensive and they are struggling with weak currencies. So it is true we have no direct exposure to emerging markets though clearly it is hindering the growth of many US companies. Is it time and are the risk reward trade offs attractive to resume direct emerging market commitments? Two of the indicators we follow that give a sense of emerging market conditions are Chinese imports and E.M. earnings. To simplify, we start from the belief that China is the key to the majority of commodity based emerging market economies. Also, as the US share of the global economy has declined, the US cannot be a big enough off setting factor to E.M. weakness. China trade has the biggest impact. Looking at Chart #4 we see that the dollar value and volume of what China imports is declining. This is bad news for the exports of developing markets that have had boom years of sales to China (all the while expanding domestic spending) and now face contraction. Even Australia as a big energy producer has its future tied to China along with Brazil, Russia and African producers. Profit growth needs to recover to support any valuation increase in emerging market stocks. Chart #5 makes clear there has been no earnings recovery. Chart #4: Chinese Imports 4

5 Chart #5: Emerging Market Earnings and Price Trends In addition, declining currencies have led to a lack of capital investment, which will lead to lower returns. A pick up in earnings per share has in the past provided an early warning of better stock prices. Rising industrial production often leads earnings increases. We are not seeing any of these hopeful indicators today, nor do we see helpful credit conditions as lenders pull back from weakened balance sheets. Investment implications: It seems pre mature to embrace a general recovery in emerging market equities. We await better business data and improvement in China s imports to become more positive. Since China is still deeply involved with rebalancing their economy away from capital spending and commodity intensive inputs, the forecast is poor for a renewed cycle of earnings growth. A longer time horizon points to the attractive demographic trends and growing number of consumers in developing economies that will likely provide better growth rates, but the fundamentals don t yet support a renewed allocation. The Dollar and oil prices are near term headwinds. J.T. Underwood Chief Investment Strategist 5