Are Emerging Markets Ready for a Strong Run?
The United States has been the Big Bull in this bull market, both economically and in terms of market returns. Since March 9, 2009 (when the bull started), the S&P 500 has vaulted 210% higher, leaving behind just about every other developed country, particularly Emerging Markets. Take a look at how these other areas of the world have performed against the S&P 500 since the bull began (note these returns are as-of time of writing):
UK [FTSE]: +81.04%
Emerging Markets [ticker EEM]: +92.8%
China [Shanghai]: +104.38%
Germany [DAX]: +114%
Japan [Nikkei]: +177.01%
Is market leadership about to change?
The power distribution of market returns across the world is warranted in my view. The U.S. has seen robust corporate profit growth since the recession ended. Unemployment has fallen from over 10% to just over 5%. The Fed rapidly reduced rates and put downward pressure on the long end of the curve with QE programs. Taken together, all this has fueled investor appetite for risk assets and the U.S. has had the “fastest car on the track.”
Corporate Profits (blue) and S&P 500 Returns (red) Have Been Moving Together
Elsewhere in the world, the case is simply not as convincing. Many countries in Europe, like Italy, Spain and France, have struggled with double-dip recessions and have spent the last few years battling sovereign debt crises and soaring unemployment. In Japan, extraordinary stimulus measures have managed only to produce uninspiring inflation and GDP growth. China too has seen growth rates slow since 2009. But, times may be changing. The euro zone grew by +0.3% in Q4 2014 and the European Commission expects full year 2015 growth to be +1.5% (take that with a grain of salt, but I don’t suspect they’ll be too far off). European QE is also in full swing and manufacturing numbers popped in Q1 alongside the equities markets there. Even China has shown increased willingness to enter the monetary easing club, having cut rates three times in the last six months with more expected. Meanwhile, the U.S. faces the prospect of rising rates and a softening pace of earnings growth, not to mention a strong dollar that puts multinationals and heavy exporters in a bit of a pinch. Could this mean that leadership might shift abroad, in which case Emerging Markets (where there is good value) could embark on a nice run? The Case for Emerging Markets • Valuations – as of March 31, the forward P/E on the MSCI Emerging Markets was just 11.9x, compared to the S&P 500 which, on the same date, was trading at 16.8 times forward earnings. One particular interest could be China, which is trading below its 10-year forward P/E average. Relative to the U.S. and the world, Emerging Markets are cheap. • Mean Reversion – during the 2003 – 2007 bull market, Emerging Markets outpaced the U.S. on the heels of a global infrastructure boom and looser credit markets. In the bull market previous to that one, the U.S. led the way. The point is leadership changes hands in the equities markets fairly frequently, so it stands to reason that at some point – though not necessarily now – Emerging Markets can gain some of that lost ground. • Global Economic Strength – generally speaking, Emerging Markets go as the world goes. With Europe looking like it may be entering a sustained recovery, China ramping up monetary stimulus efforts and the U.S. chugging right along, Emerging Markets may have more coattails to grab onto. The Case Against Emerging Markets • Stronger Dollar Makes Debt Financing More Expensive – many Emerging Market countries borrow in dollars and, with dollars being more expensive, it takes more local currency to meet debt obligations. This could mean that some Emerging Market countries have to drain reserves to pay down debt, preventing that capital from being re-invested in the country. • Lower Commodities Prices May Hurt Exporters – there are quite a few energy/commodities exporting Emerging Market countries (Russia and Venezuela being the big names) that are taking a hit from lower prices. Lower revenues for those countries means the potential for budget deficits and the need for cutbacks on state-run programs, which for some countries are a primary driver of GDP growth. The Bottom Line for Investors Leadership amongst countries and sectors changes hands often. Fundamental drivers are there, but simple cyclicality can also play a role. At the end of the day, it’s not a matter of perfectly timing your entry into U.S. stocks while ditching foreign, or vice versa.
The smarter approach is to diversify your portfolio across the world and ten sectors, and make informed decisions about when you want to add a little weight to an area you think could outperform. In this case, Emerging Markets are not only cheap, but they have also not yet delivered the outsized returns we saw in the 2003 – 2007 bull. They could be due.
The plus for Emerging Markets is that they provide the opportunity to diversify your portfolio — resulting in the possibility of high returns. However, the caution is that they also come with high risk. Nevertheless, because Emerging Markets are expected to grow faster than the U.S., they merit careful consideration.
In fact, you might also consider blending investments in both emerging markets and developed nations as we do in Zacks Investment Management's International Strategy. A risk-managed approach such as this can add diversification and growth to your portfolio. But before you re-allocate, it is important to ask— how does the U.S. compare to foreign markets? What is the projected U.S. GDP growth in the coming months — will the U.S. decline happen soon? Has risk appetite returned? Zacks Investment Management just released its market outlook for June, 2015. I invite you to download this exclusive report now to gain a competitive edge in the market.
Free Download: Zacks Market Outlook (June, 2015)
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