So said GMO’s John Thorndike in a recent Fortune article, and it resonated strongly with us. In WILTW July 12, 2018, we argued that with the MSCI EAFE Index trading near a five-decade low relative to the U.S. market, it is not only wise but prudent to reallocate to less-crowded markets in the global economy. As emerging markets continued to sell-off going into the autumn—on fears of continuing U.S. interest-rate hikes attracting capital from overseas, combined with the damaging effects of the trade war on EM economies—the rationale behind rebalancing portfolios in favor non-U.S. markets has only gotten stronger. The following chart shows that the MSCI World Index ETF (ACWI) is trying to lift off a double-bottom relative to the iShares MSCI USA Equal-weighted ETF (EUSA). If last week marked the coming end of this cycle’s relentless Fed rate hikes, the attractiveness of EMs should rise even further.
The bear case for emerging markets has been a “crowded trade” all year, judging by the lack of investor sponsorship. The following chart from the IMF’s October 2018 World Economic Outlook (WEO) illustrates the sharp negative reversal in EM equity and bond-market inflows since last spring, when problems began to emerge in Argentina and Turkey (see WILTW May 10, 2018). And, while money was flowing out of EMs, it was flowing into the U.S.: according to data cited by The Wall Street Journal, foreigners owned an estimated 15% of U.S. shares in 1Q-2018, compared to 11% a decade earlier.
But, the tide may be turning: Bloomberg reported this week that investors pumped over $2.6 billion into EM-stock and bond ETFs last week, which was the most in 10 months and a sign that the worst of the capital outflows is behind us. Importantly, two of the major factors behind the bear argument—fears over additional rate hikes and weak trade flows—have been short-circuited over the past week, after Jay Powell’s speech and the G20 meeting.
Moreover, EM valuations are even more compelling than they were at midyear, which is likely to attract new capital: according to Rob Arnott at Research Affiliates, the CAPE for emerging markets approximates 12.5x, versus 31x for the S&P 500, making EMs a statistical bargain.
It is often argued that U.S. stocks deserve a valuation premium due to their emphasis on technology and services, but those same factors could lead to sharp price declines whenever results disappoint their lofty expectations, as we have seen in recent months. Investors in U.S. equities have gotten used to 20%-plus earnings gains in 2018, on the heels of lower corporate tax rates and pre-tariff inventory buildups—but as those factors wane, S&P 500 earnings growth is likely to fall into the single-digits next year, at best. As more investors begin to question the rationale behind paying higher multiples when earnings growth is decelerating to less than 10%, then EM equity markets could outperform simply by demonstrating that things are not as bad as investors had previously feared.
Meanwhile, two graphics from the IMF’s WEO stood out as reasons why the valuation discount for EMs may be overdone. First, EM economic growth is likely to be maintained at a robust level, between 4% and 5%, from 2019 to 2023—with greater balance between private consumption and fixed investment versus advanced economies (AEs). Indeed, as a percentage of GDP growth, fixed investment (blue bars) is likely to shrink by half in the AEs while actually growing marginally in the EMs.
And, higher levels of investment are likely to support more robust growth in consumption. The Financial Times of December 3rd carried an article headlined “Recent Sell-off Shunts Some Nations Into Bargain Territory,” which encapsulated the reasons why EM economic growth is likely to continue outperforming the AEs: “In the next seven years, another 1bn people are expected to join the emerging middle class, according to the Brookings Institution. Of this, about 90 per cent are likely to be Asian, of which about 500m will be Indian and 300m Chinese. This should continue to support not only the consumer and infrastructure sectors across Asia, but also the materials and commodity-producing countries, such as Brazil and Russia.”
On the other side of the coin, the persistently-weak productivity growth that has prevailed in the U.S. justifies raising the level of investment relative to GDP above recent averages, but the reverse is likely to happen as entitlement spending swallows an ever-larger share of the federal budget. This will not be conducive to robust U.S. growth going forward.
The second noteworthy graphic appears below, and shows that as a group, Emerging and Developing Asia, Latin America, and other EM economies have a combined level of gross public indebtedness, relative to GDP, that is lower than AEs as a whole and the major AEs, including the U.S. Given the rapidly-aging populations in the developed world, higher levels of public indebtedness will add to government spending burdens as interest expense accelerates, crowding-out the private sector.
The iShares MSCI Emerging Markets ETF (EEM, $41.02), which has underperformed the S&P 500 all year, appears compelling at current levels. The price has declined over 20% from its 52-week high, but the stock appears to be breaking-out of a falling-wedge pattern, which portends further gains (see first chart below). Additionally, the R/S chart appears to have bottomed-out (second chart), and if this turns out to be a false breakdown below the double-bottom in 2016 and 2017, it would add to the bullish case.