In this edition of CA Answers, two members of our Global Investment Research team discuss the recent sharp rally in emerging markets. Aaron Costello addresses the factors behind the rally and their sustainability, while Sean McLaughlin reviews the valuation case and return potential for emerging markets equities.
Aaron Costello: In my view, the rebounds in emerging markets assets—including equities, currencies, and debt—and in commodities stem from the same factors: the Federal Reserve turning dovish and the US dollar weakening. The rally could run further in the short term, but will ultimately falter heading into 2017 as oversupply issues cap upside in commodity prices and rising US rates and renewed US dollar strength weigh on emerging markets assets.
The correlation of emerging markets equities and currencies to the price of oil and the correlation of oil to the US dollar has been near-perfect since 2014. Thus it should be no surprise that the recent bottom in global equities and the price of WTI crude oil coincided with Fed Chair Janet Yellen’s testimony to Congress on February 10 that the Fed was willing to delay monetary tightening given uncertainty in the global economy.
Indeed, recent market action is very reminiscent of the late 1990s. Rising US rates and a strong dollar in the mid-1990s put commodity prices and emerging economies under pressure, culminating in the Asia/Russia crisis in 1998, which caused a mini-panic in global financial markets and saw oil fall back to $10 a barrel. Yet the Fed cutting rates in 1998 helped weaken the US dollar, triggering a relief rally in emerging markets and commodities. Emerging markets equities actually outperformed US equities in 1999, despite the latter entering the final phase of the tech bubble. Renewed Fed tightening over mid-1999/2000 sent the US dollar higher, halting emerging markets’ outperformance and the rebound in commodities, while the US dollar continued to climb until early 2002 despite aggressive Fed rate cuts as the US and global economies fell into recession. The bull market in emerging markets and commodities did not begin in earnest until 2003, due in part to broad US dollar weakness and a global recovery. A similar outcome may be seen this cycle, with the true bull market not occurring until after the next recession.
At the same time, fundamentals also suggest reasons to be skeptical. The emerging markets/commodity bull market of 2003–10 occurred amid widespread undersupply of commodities stemming from decades of underinvestment. Today, nearly every commodity remains oversupplied, which will cap the upside in commodity prices and emerging markets commodity currencies. For instance, the inflation-adjusted price of oil was largely range-bound between $20 and $40 from 1986 to 2003.
China is the other key factor. Stabilization of China’s currency and economy can also be credited with helping boost sentiment toward emerging markets and commodities. Yet I would argue the renminbi’s stabilization largely reflects broad US dollar weakness (i.e., had the Fed not turned dovish, the People’s Bank of China may have been forced to devalue the currency), while the upturn in Chinese growth indicators is due in part to a renewed surge in credit creation that does not seem sustainable. While supporting the industrial side of the economy may help in the short term, it may actually intensify the longer-term slowdown in Chinese growth. Another “China scare” that shakes investors’ newfound confidence could be on the horizon.
The strength of the recent rebound should be of no surprise, given how beaten up and oversold these assets had become. Ongoing weakness in the US dollar should allow the emerging markets/commodity complex to continue to rally in the short term, especially since neither momentum nor valuation measures are stretched yet. However, as I recently discussed, history suggests that the strong-dollar cycle is not yet over, and that dollar weakness at this part of the market/economic cycle is typical and prelude to renewed strength.
Thus, investors should be prepared for this recent bout of strong performance from emerging markets to be short-lived. While the next multi-year bull market in emerging markets is not too far away, it isn’t here yet.
Sean McLaughlin: Regardless of whether the factors behind the recent rally are sustainable, good things happen to cheap stocks. Short-term performance cannot be predicted effectively, but history tells us that when equities start out at the depressed levels that emerging markets stocks hit in late January, they typically do well over the next year, and that over the long term, the solid performance record is even clearer.
Based on historical analysis of emerging markets and individual developed countries, when equity valuations started out below ten times normalized composite earnings, subsequent 12-month returns were negative about 13% of the time, but the median subsequent return was 18.6%, and more than four times out of ten the return topped 25%.* Good things, indeed! And low starting valuations have tended to result in strong five-year and ten-year returns as well. Emerging markets equities traded at a composite normalized price-earnings ratio of 9.7 in January.
Besides their very low valuations, what else supports the case for a continued emerging markets rebound? My colleague Aaron notes that commodity prices and prospects for emerging markets are related. I agree. Commodity prices are seriously depressed—as of April 30, prices of 19 of the 22 commodities that we track in our broad basket remained below their historical inflation-adjusted averages—and supply growth appears to be moderating in some key commodities, creating conditions for a potential tailwind for emerging markets.
One beneficiary of rising or even stabilized commodity prices would be emerging markets corporate earnings. After falling 8% in 2014 and an additional 5% in 2015, the analyst consensus pencils in a moderate 8% rebound in earnings this year. But at these depressed levels (real per-share earnings are back to 2010 levels), a boost in commodity prices could translate to positive earnings surprises.
What else could impact returns for emerging markets equities? Aaron notes the importance of a dovish Fed and dollar weakness. Certainly these have contributed to the recent bounce, and a reversal in either or both could be a headwind, but predicting the likelihood, timing, or even impact of such changes is tricky at best.
Momentum and market sentiment are additional swing factors that are difficult to assess. While investor flows have been supportive, emerging markets trail developed markets according to one of the most reliable price-momentum metrics.
In all, valuations provide the most dependable signals for long-term investors, though the signal for short-term performance is considerably less consistent. We believe that emerging markets equities are compelling values especially relative to US equities, and we advise investors with long time horizons to continue to overweight them. Indeed, evidence points to a reasonable likelihood that their recent strength will persist over the short term as well. As we have often opined, long-term investors would be best served to focus on what’s cheap.
* We reviewed the valuations and subsequent returns history for emerging markets as a group, and for the eight individual developed markets countries for which we track normalized composite valuation multiples on a regular basis (Australia, Canada, Hong Kong, New Zealand, Singapore, Switzerland, the United Kingdom, and the United States). Returns are in local currency terms. There were more than 450 instances of equity valuations starting below ten times normalized composite (Shiller, return on equity-adjusted, and trend line) earnings. Note that many of the time periods are partially overlapping or are shared across multiple countries.
Aaron Costello and Sean McLaughlin are Managing Directors on the Cambridge Associates Global Investment Research team.