The arguments for owning EM are well-documented – young populations, low debt to GDP ratios, high growth rates, supportive demographic trends (with a few notable exceptions) and plenty of room to increase productivity are just some of the most common qualities cited for owning EM. Despite all these tailwinds, both earnings and market levels are below pre- and post-crisis peaks. During what might end up being the longest expansion in US history, emerging markets stand out as a notable underperformer. Since the market bottom in March 2009, the S&P 500 has returned nearly 400% cumulatively versus the MSCI Emerging Market Index up less than 200%. The difference is even more pronounced after EM’s initial bounce post-crisis. Since the end of 2010, EM is up just more than 2.0% annually versus the S&P 500 up over 13% during the same period. Excluding dividends, the price index is negative over the seven-year period.
There are many challenges to investing in emerging markets – over 20 countries, nearly 1,000 securities, different regulatory and currency regimes. Annual volatility in the low to mid 20s is commonplace. For a variety of reasons, EM goes through multiyear cycles with tremendous out/underperformance relative to developed markets. This year appears to be staying true to form. Since reaching multi-year highs in the January the index is down nearly 14%. If we peel back that performance, approximately -4% can be attributed to the currency moves. Consensus forward EPS has only come down marginally since the January highs (~1%). As a result, EM equities have gotten cheaper and are trading around 11.5x forward earnings which is down from a high earlier this year of over 13x.
The big question, of course, is whether this pullback is almost over or there is more pain to come. To be sure, the near daily tennis match of trade war shots between the US, China and Europe isn’t helping matters. To the extent a portion of this pullback is due to trade war risk, we see two likely outcomes. First, cooler heads prevail, and all sides realize a protracted trade war could potentially derail the first coordinated global expansion in over a decade. This scenario likely ends in China and/or Europe agreeing to small increases in imports from the US to give the US administration the PR victory it desperately needs. The second scenario ends in small tariffs being levied by multiple sides that have very little impact on the economies involved. Consider the current political backdrop and our President: if President Trump is anything, he is responsive to approval ratings and what people think of him. He has a midterm election in four months, and if he has any hope of accomplishing anything before 2020, he needs a PR victory that prevents a flip of the House. He will accept a promise to increase imports or more friendly treatment of US exports (reduced tariffs and/or reduced subsidies of local products) whether those assurances ever come to fruition or not.
Before concluding this note on EM, we want to point out an interesting (and somewhat tangential) data point on technology. Recently, technology’s weight in the S&P 500 surpassed 25% (currently 26%), a dominant position not seen since 2000 (at the peak of the dotcom craze) when the sector briefly topped 30%. It took only two years for tech to drop from 33% of the index to less than 13% (where it bottomed). We are pleased to report that “this time is different” in at least one way: the sector trades at 18x forward earnings compared to a breathtaking 50x in early 2000. The point is, technology makes up a very large (and growing) percentage of the S&P 500. In the rest of the developed world, tech is a much smaller industry – tech makes up less than 7% of the developed market ex-US index. More similarly to the US, technology makes up nearly 30% of the EM index, which is relatively larger than tech’s representation in the S&P 500. In 2008, tech was just 10% of the EM index. If nothing else, the composition of the EM index is hugely different today versus 10 years ago, which adds another level of complexity to investing in the space.
At Custos, we think EM plays an important role in most of our client’s equity portfolios. While we think it makes sense to increase or decrease total exposure to EM, it rarely makes sense to be fully uninvested in the asset class. For example, from the middle of 2011 to early 2016 the EM index was down over 30% which was made even more painful considering what US large cap stocks did over the same period. Over the next two years, EM nearly doubled. If you are going to invest in EM at all, you cannot miss that kind of move because you were uninvolved when owning EM was out of favor.
Finally, a quick thought on the Department of Labor (DOL) Fiduciary Rule. This week, a decision handed down by the US Fifth Circuit Court of Appeals effectively killed the DOL rule that required brokers act under a fiduciary standard when advising on retirement accounts. There is no reason why as an industry we cannot avoid overly burdensome regulations and at the same time agree all advisors should be held to a fiduciary standard. We see merit in 5th Circuit’s decision that the Department of Labor is not the appropriate regulatory body, however, the fact that a broker or an investment advisor has the option not to act in the best interest of his or her clients is astonishing. It is common to recommend individuals ask their investment provider if he or she is a fiduciary. Go one step further. Ask them to show you where they are legally bound to act as a fiduciary. At Custos, “fiduciary” is written into every contract we sign with a client.