By Stephen Greco, CEO
The Siren Song of Emerging Markets
Since making the transition from the broker-dealer side of the industry to the registered investment adviser side, around 2011, no asset class has been more interesting to me than Emerging Markets. By 2011, many investment advisers had fallen in love with Emerging Markets as an asset class and decided to pile significant portions of their clients’ portfolios into this space. Some advisers had well-thought-out arguments that pointed to population growth in these markets, a growing middle class, exceptional performance from 2001 to 2010, and an increased risk premium as factors that should lead to higher returns over an extended period. Other advisers really didn’t have an argument and instead decided to pile into Emerging Markets because it was the “hot” asset class. Even worse, some advisers applied a lazy “gambler’s fallacy” type of logic and reasoned that, because Emerging Markets had a couple lagging years to start the decade, they needed to buy more since it was due to bounce back. “Buy low, it has to come back at some point” is a common refrain I have heard over the years, which really is no different than saying you should bet on black in roulette after red has come up 6 or 7 times in a row. I even saw an article the other day, written by a member of the investment committee of a prominent firm, that stated that investors need to have exposure to foreign stocks, even though they won’t lead to the highest returns. Such advice is emblematic of the “follow the crowd” thinking that has unfortunately become so prevalent in the market. Diversify because you are told to do so, and be happy with lower returns. Shouldn’t we strive for something better? Something more strategic and thoughtful?
To set the context for why this is all so fascinating to me, it is important to understand the returns we have seen from Emerging Markets over the last couple of decades. From 12/31/99 to 12/31/09 the S&P 500 had an average annual return of -2.72% per year. It is a period often referred to as the “Lost Decade” for US stocks, and it was the only decade the S&P 500 recorded a negative annual return according to data that Forbes had collected going back to 1926. Emerging Markets, on the other hand, had an average annual return of 9.78% per year during that same period, out-performing the US stock market by about 12.5% per year for 10 years. That is a tremendous difference and, because of that performance, many advisers started to allocate more and more of their client’s portfolios into Emerging Markets, blindly expecting the same types of returns for this current decade. Unfortunately, they have been horribly wrong. From 12/31/09 to 7/31/18, Emerging Markets had an average annual return of 1.59% per year. Not quite negative like the S&P 500 in the previous decade, but certainly nothing to write home about. In contrast, the S&P 500 had an average annual return of 23.55% per year, or about 22% more each year for the last 8+ years. So what changed?
We believe there are three key questions every investment committee should ask to guide their analysis and make better-informed decisions for their clients:
1) What has happened?
2) What is happening?
3) What do we think will happen going forward?
What has happened?
Gambler’s fallacy aside, we do believe in reversion to the mean and we factor it into our thinking when we develop portfolios. This is simply a fancy way of saying that if something hasn’t done well for an extended period then it should be on our radar because asset classes perform in predictable ranges the longer the period you are measuring. Therefore, if something has done poorly for an extended period, it could do much better than other asset classes in the future. After all, money finds value. The mistake many advisers made, in our opinion, was that they saw underperformance in a small period of time (2011, 2013, 2014) and assumed that things would spring back after that. This is even more mind-boggling when we just came off a decade of underperformance for the S&P 500. After all, if the US markets underperformed for an entire decade, why wouldn’t it be logical to assume that Emerging Markets could do the same? This would be a very simple conclusion to draw, and one that would have been right if they simply would have underweighted the asset class based on the previous out-performance alone. However, while we believe in reversion to the mean, we feel more thought needs to go into investment decisions than that alone.
What is happening?
During the current decade there are a few factors we believe have contributed to the underperformance of Emerging Markets. First, as stated above, money finds value. If an asset class underperforms for more than a decade, at some point people will take notice. Second, we had two extensive declines to the market during the previous decade. In the early part of the 2000’s we had the tech bubble followed up by the financial crisis in 2007 and 2008. These shocks to the market impacted the way investors think. It decreased their appetite for risk and encouraged them to invest in things they were more comfortable with and understood. This led people to invest more in their own backyard (i.e. US stocks). Third, there was a significant drop in interest rates in the decade beginning in 2000. The prime rate, which is the interest rate that many loans are based on, started around 9.5% at the beginning of the decade and decreased to around 3.25% by the end of the decade. The Federal Reserve tries to keep rates low to stimulate investing and risk-taking, so this incredible movement in rates really helped prop up Emerging Markets. In the current decade, we have seen an increase in rates from 3.25% to 5.00%. It isn’t a tremendous increase, but the bottom line is that rates have gone up, which hurts the riskier asset classes, including Emerging Markets. Lastly, over the past two years, the Trump administration has emphasized an “America First” approach to, among other things, US trade policy. Specifically, the administration has been aggressively trying to renegotiate trade deals to America’s benefit. This has caused more concern for Emerging Markets, especially in China, which has been singled out as the primary trade offender by the Trump administration. China represents about 30% of the Emerging Markets Index. So, what should investors do? Think about the future.
What do we think will happen going forward?
Now that Emerging Markets has significantly underperformed for the last 8.5 years, we feel it is time for investors to take notice. It isn’t a sign in and of itself that investors should allocate more to Emerging Markets, but it is a step in that direction. We also want to look at P/E ratios compared to historical norms. Currently, the S&P 500 is trading at a P/E ratio of 24.06 based on forward looking metrics (see the Wall Street Journal link, below). Emerging Markets is trading at a P/E ratio of 11.45 based on forward expected earnings as of 7/31/18. While we expect interest rates to continue to rise over the next couple of years, we think the pace of these hikes will slow. Since 2015 we have seen six interest rate increases totaling 1.75%. We expect three more hikes over the next couple of years, which would not be as significant as what we have seen previously. Lastly, we think the political climate is starting to take a turn towards completing trade deals, rather than imposing tariffs. Republicans have been more vocal about tariffs than they have about any other areas of disagreement with the President. Trade is becoming a big issue in several swing districts, and we expect to see the administration work feverishly to get as many deals done as possible before the mid-term elections. We saw that this week with the US and Mexico nearing an agreement on a trade deal. Canada appears to be next, and the administration continues to negotiate with China as well.
Based on these factors, we think it is a good time to allocate more capital to Emerging Markets. Clients have already received a newsletter with our specific trades. For any prospective clients that are interested in our investment philosophy or services, please don’t hesitate to contact me at email@example.com or by phone at 630-230-6840.