The answer depends on what kind of investor you are. Long-term investors will find valuations for cyclically oriented opportunities like emerging markets equities and natural resources equities have improved and provide more attractive prospects for long-term returns. However, such investments are not for the faint of heart. Shorter-term oriented investors that would find it hard to hold on in the face of further market weakness may be best served by moving slowly.
Risk assets have taken a beating in recent days, with some markets now down as much as 20%–30% from spring highs. Even US equities, which have been relatively resilient in recent stress periods, have suffered a 12% correction through today’s close. Markets have been seeking to digest the implications of China’s sharp deceleration in GDP growth as well as the prospects for US Federal Reserve tightening.
Much of what has become cheaper in recent days was already relatively cheap, so investors that have been leaning into these value opportunities are faced with the question of whether it makes sense to rebalance or maintain overweight positions. Time horizon is critical when thinking through prospective opportunities, particularly those that are geared to the economy.
Emerging markets equities, particularly in Asia, stand out as attractive among broad categories of cheap assets today. We have been recommending an overweight to Asian emerging markets/Asia ex Japan equities relative to US equities since the start of the year. While US equities have declined, Asia has been harder hit as its closer ties to Chinese growth have taken a toll on market expectations. With the recent declines, Asia ex Japan trades at a normalized P/E valuation roughly 23% below its historical median, while US equities trade at valuations 27% above. If relative valuations were to revert to their historical median ratio through price changes only, investors underweighting US equities and overweighting Asia ex Japan would earn 30%. This provides a significant opportunity for patient investors.
The biggest risk to Asia ex Japan and emerging Asian equities is a downturn in earnings amid continued or accelerated weakness in Chinese earnings. Investors will have to wait and see whether a weaker Chinese currency and monetary policy easing will support current economic growth rates. Those countries in the region that rely most heavily on China as an export market (e.g., Korea, Singapore, and Taiwan) may see both earnings and currencies under pressure, as has been the case for these countries’ currencies in recent days. A weaker RMB will place further downward pressure on emerging markets and Asian currencies, although MSCI Asia ex Japan is somewhat insulated, as 42% of the index is in Hong Kong dollars, which are pegged to the US dollar.
We prefer these China-related risks to the greater currency and commodity risk we see in emerging markets as a whole. Asian emerging markets are net commodity importers in aggregate, should have greater currency stability, and to the degree that developed markets benefit from lower commodity prices, Asian emerging markets that export non-commodity goods and services should benefit. We remain constructive, taking a long-term horizon, and would seek to rebalance to modest overweight positions, building positions on further weakness relative to US equities. For those with shorter horizons, it could be a rough couple of years for China and volatility is likely to remain. While valuations are attractive and markets have sold off considerably, downside risk remains, particularly if investors increase capital outflows as they tend to in emerging markets sell-offs. According to data from the Institute for International Finance, the recent cumulative net outflows from emerging markets equities have been less than one-third that experienced in the 2013 Taper Tantrum. A go slow approach may be preferable.
Natural resources equities (NREs) also stand out as cheap. In fact, they trade at a more than 30% discount to their historical median cyclically adjusted P/E. However, we regard these equities as less attractive than emerging markets equities, particularly in Asia, where we prefer to concentrate cyclical risk exposures. We believe that Asian emerging markets equities have a better chance of recovering sooner than NREs and have more confidence in our emerging markets equities valuation analysis. However, we have recommended overweighting NREs relative to commodities, while underweighting inflation-sensitive assets on the whole, and maintain this recommendation today. NREs offer better value than commodities and come with considerable positive carry given their 4.5% dividend yield, in contrast to no return from commodities’ collateral and a trailing 12-month roll yield at -5% as of the end of July with continued contango in oil and many other key commodity-index components.
Heightened volatility also provides opportunities for nimble active managers to add value. Temporary liquidity-induced market dislocations surely provided opportunities for such managers to add value to portfolios. Similarly, spreads in high-yield bonds have widened considerably. While this has largely been attributable to wider spreads in energy and metals & mining issues that pose elevated default risks, thoughtful managers can likely find ways to benefit. Most investors need not do anything to take advantage of such opportunities, as many hedge funds and credit funds are searching for value in these areas.
While markets have sold off, some considerably, and some markets are at oversold levels, downside risk remains amid economic and policy uncertainty. All investors would be well served to maintain thoughtfully diversified portfolios consistent with their risk tolerance and return objectives. Inclusion of defensive assets is critical to withstanding volatility and taking advantage of future opportunities that may develop. Today, we would focus defensive positions in low equity beta hedge funds with less equity and credit exposure, high-quality sovereign bonds, and cash.
Celia Dallas is Cambridge Associates’ Chief Investment Strategist.
Related recent publications:
VantagePoint: Third Quarter 2015 (published July 13, 2015)
Value in the Oil Patch, for Investors With a Strong Stomach, August 2015
The Investment Compass Points Due East: Asia’s Appeal to Emerging Markets Equity Investors, June 2015
China: Prepare for Stress, October 2014