“Despite the size and strength of the US economy, a single country trying to take on the world is extremely likely to create more problems at home than it does abroad”
- Ben Inker
After sitting atop the asset class leaderboard in 2017, with returns of 37%, emerging market equities were projected by many to have another strong year in 2018. Goldman Sachs believed emerging markets were in “the early stages of a multi-year recovery.” Northern Trust highlighted that EM offered attractive valuations and improved growth prospects relative to the U.S. WhartonHill also made the case for emerging markets to continue to perform well over the long-term, noting inflows seemed to be in the early stages of expansion and earnings were picking up steam. Emerging market returns have not met expectations, however, lagging U.S. stocks this year with a decline of around 10%, YTD. The short-term underperformance, in the face of long-term potential, warrants a closer look if the volatility in EM is just noise or a bigger concern.
The primary reason for the gap in YTD performance between U.S. and emerging market equities has been dollar related. On average, emerging market currencies have fallen 14% vs. the dollar.
For a fund or ETF that purchases shares of EM stocks in a foreign currency, the translation back to the dollar for a U.S. based investor has been the primary detractor in returns this year. The dollar has been strong due to accelerating growth in the U.S., which registered GDP growth of 4.2% in the second quarter of this year, the best quarter of growth in four years.
Conversely, emerging market currencies have been weakened by an increase in negative sentiment around the potential for $200 billion of trade tariffs on China, combined with economic crises in Turkey and Argentina (their currencies have fallen around 50% vs. the dollar). To be sure, those two countries are small players on the global stage and their economic issues are unique to themselves. The possibility for a domino effect to occur with other countries is possible; however, we think it is unlikely that these problems spread across the entire landscape of emerging markets.
Where the attractiveness in emerging markets continues to reside is in potential economic growth and discounted valuations. A comparison to our country may help draw the growth potential out further. In U.S. marketing circles, there is often a focus on what “millennials” are purchasing and where their dollar spend is going. This demographic, approximately ages 25-35, consists of around 66 million adults in the U.S., and this group is a key driver of consumption trends. By comparison, within China alone, there are 300 million millennials, 4.5 times that in U.S. Not only is the consumer base significantly larger than in the U.S., disposable income in China is rising at a 9.0% rate, annually. By comparison, income growth in the U.S. is 3.0%. All things considered, there are younger populations in emerging markets, with an increasing ability to spend their money compared to an aging population in the U.S. with just modest wage growth. Over the long-term, emerging market consumers will continue to drive growth and ultimately equity returns to levels that we believe will be in excess of the U.S. stock market.
The problem in the short-term is dealing with the volatility. Emerging markets can provide some of the best and worst years with respect to how they compare to other equity indices, but it is important for investors to be patient during the volatile periods so as not to miss out on the best periods. The following graphic from Oppenheimer highlights the returns an investor generated in emerging markets over the last twenty years. If they maintained their investment over the full time period, they generated a 10% annualized return.
Yet if they missed the best year in that time period, their annual return was just 7.29%. If they missed the best three years, it was just 1.96%. In order to not miss the best years of returns, investors must remain discipline during some of the worst periods of volatility, some of which we are experiencing right now.
The introductory quote to this letter is from Ben Inker, of GMO, a well-regarded investment manager. GMO believes emerging markets warrant increasing allocations in their portfolios and they note the following: “On a forward-looking basis, there are risks. There are always risks to emerging equities…but as for the most talked-about risk today – a trade war – it is not obvious that emerging equities are truly in crosshairs that what is currently unfolding is not a truly global trade war, but the U.S. taking on the rest of the world.” We will continue to monitor our emerging market allocations closely to monitor any potential change in fundamental strength, but at present, we continue to believe they represent a compelling long-term value with very strong return potential. Investors would be best served by staying the course in spite of recent volatility.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data via Bloomberg. Charts via JP Morgan and Oppenheimer.