With football season upon us, it is becoming obvious even after just several weeks that some teams seem ready to capture the championship while others will need to rebuild and wait for better times. If you are a fan cheering for one of these rebuilding teams, it can be frustrating to wait for your team to take the necessary steps that will allow them to thrive.
It is no different when we make our allocation decisions. While we do not root for one asset class over another, we certainly have studied the longer-term winners and losers. The emerging markets equity asset class seems to be one of those teams that has been a long-term winner, although it occasionally suffers from some difficult years. While our analysis shows that the long-term prospects of this asset class remain robust, primarily because of demographic trends and strong long-term GDP growth projections of these countries, the shorter-term environment continues to be unfavorable.
Emerging Markets Equity: When to Under- and Overweight
Emerging markets equity has a history of either being the top or bottom performer when compared to other asset classes globally. In fact, over the past 15 calendar years ending 2017, this asset class has either been the best or the worst in 12 of those years. When compared to other major asset classes, such as the S&P 500, the Russell 2000 (small cap) or the MSCI World ex.-U.S., this asset class performs at extremes. Therefore, determining when to overweight or underweight this asset class within a well-diversified portfolio can pay off for investors.
Obstacles in the Short Run
The relative underperformance of this asset class is nothing new. After very strong absolute and relative performance in 2017, emerging markets equity has recently struggled from a combination of tighter global liquidity conditions, local political scandals and even some policy errors (such as Turkey waiting too long to raise interest rates). After strong gains in January, the asset class has been challenged, weighed down by the strength in the U.S. dollar and higher U.S. interest rates (see Exhibit 1).
U.S. trade policy is another negative component in the equation for emerging markets. President Trump wants structural reforms, which include lowering tariffs to be more in line with other countries and increased protections for U.S. intellectual property. As China represents 30% of the MSCI Emerging Markets index, you can see that difficult times could potentially continue for the foreseeable future.
The Elephant in the Room
Recent data has confirmed that China's growth is slowing, having peaked at 6.9% year-over-year in 2017 and forecast to grow at 6.6% and 6.2% in 2018 and 2019 respectively, according to the International Monetary Fund. Some strategists believe China's pace of growth is lower than what is widely reported. There are many factors contributing to this slowdown, including stricter financial regulation, a tightening of financial conditions due to the Fed raising rates, and a decline in consumer spending as evidenced by the lowest level of retail sales in 15 years. Real estate and infrastructure investments have also declined as a result of the deleveraging efforts of the Chinese government. The challenges facing China are detailed further in China's Balancing Act, written by BNY Mellon's head of Global Investment Strategy, Alicia Levine.
Now trade uncertainty is in focus, with many concerned that an escalation of tensions could lead to a currency war and further capital flight out of China. It isn't helping China's case that they rely on U.S. consumers for some USD $500 billion of exports per year. While a 10% tariff on USD $200 billion in goods, put into effect on September 24, 2018, only amounts to a small percentage of China's GDP, additional tariffs could weigh on growth or prompt China to take retaliatory actions.
We have already seen China take some steps to stimulate growth and offset the negative impacts of tariffs by implementing recent tax cuts to those at the lowest income levels, lowering reserve requirements and imposing cost controls within many Chinese companies. As trade tensions escalate and negotiations potentially extend into next year, China will need to try to balance its stimulative efforts while maintaining business and consumer confidence so as not to exacerbate any slowdown of growth. This may be why President Xi is trying to distance himself from the trade talks so as to not be associated with the negative effects. Is Trump's belief that trade wars are easy to win proving to have some merit? Time will tell.
The Long Run Still Bodes Well for the Asset Class
With all the near-term obstacles for emerging markets equity, our longer-term view remains quite favorable. We continue to recommend exposure to this asset class within a well-diversified portfolio, although we are underweight the asset class compared to a client's long-term strategic weighting. Over the past 10 years, emerging markets have delivered solid returns, with an average annual gain of 5.2% (in USD). Our long-term outlook also remains positive, with emerging markets equity expected to deliver 8.3% (in USD) based on our capital market assumptions, which look out seven to 10 years. Our expectations are based on very strong demographic trends and the higher growth potential that exists within many emerging market countries, as well as stronger earnings growth. However, the asset classes comes with a higher level of volatility, making the decision of when to overweight and underweight the asset class extremely important.
Waiting for the Right Environment
Our market cycle research has shed some light onto how to determine when emerging markets equity could be a strong performer. While the asset class may do well at any point in an economic cycle, our analysis shows that it performs best in an economic recovery's early stages. As such, emerging markets tend to outperform when the world is coming out of a global economic recession.
Although past performance is not indicative of future results, history does show us that emerging markets equity has had a perfect record of leading the way out of recession by delivering the strongest absolute and relative performance as compared to other major asset classes. Over the past 15 years, emerging markets equity has led all other major asset classes out of a recession or slowdown. Emerging markets equity was the top performer in 2003, as markets recovered from the 2001-2002 recession, and in 2009, as the world began to recover from the financial crisis. Even 2012 saw emerging markets equity on top, following the recovery from the Eurozone's slowdown during 2011.
The Investment Strategy Committee, which I chair, has been recommending an underweight to this asset class for the last four years because we anticipated slower growth in developing countries, U.S. dollar strength and diverging global monetary policy. Even though emerging market valuations have gotten cheaper, currently trading at 11.5 times 12-month forward earnings, we believe that now is not the time to increase exposure. Given the research just highlighted, you can generally expect us to have an overweight to this asset class after a recession has taken hold and we see the end of that slowdown in sight. Until then, expect us to continue to maintain an underweight to the asset class as we wait for the emerging markets equity team to rebuild and wait for an environment where it has historically outperformed.