Recent market volatility has made many re-examine their emerging markets (EM) allocation. The one-way market rally of 2017 has given way to a state of volatility all-too-familiar to the longer-term emerging market investor. So where do investors go from here? We like to point to two contrasting perspectives which influence our EM outlook.
On the economic front, the underlying data is unequivocally positive. For the first time in decades, we are experiencing a synchronized global expansion, with the United States, Europe, Japan and EM engaged in a virtuous cycle of economic growth. Such statistics as manufacturing orders, employment and corporate earnings are hitting levels not seen since prior to the global financial crisis, setting the stage for possibly one of the strongest global expansions on record.
However, on the political front, the world faces many challenging situations, with increasing threats of trade wars and military standoffs, paired with the diminished power of the multinational organizations which have historically resolved these threats. The relatively crisis-free environment of the past several years is less likely to be repeated in the coming year.
What is an EM investor to make of these two contrasting viewpoints for 2018? We would advise the long-term holder of this asset class to focus on the economic data, while being prepared for times of elevated risk arising from the political tensions in play.
Concerns about EM. . .
While 2017 was a year of strong returns, it was very unusual in the lack of any significant “risk-off” events, which have historically been the norm for this asset class. One concerning aspect for 2018 is that the United States has turned from being a dampener of such risks, to being the source of such risks (recent examples include the protracted NAFTA negotiations, cutting ties with Pakistan, and the increased trade tensions with China). We view it as likely that 2018 will see a major drawdown in EM equities as a result of political situations boiling over. Investors who have been lulled by the near-perfect market conditions in 2017 should recheck their risk tolerances before proceeding.
. . . Could be alleviated
At the same time, we believe the underlying strength of the global economic expansion will continue to benefit EM equities. EM exports are on a strong uptrend, fed by the coordinated growth of not only the developed economies, but, increasingly, other emerging market economies. In addition, as the below table shows, the asset class is trading at historically low multiples, allowing for a higher degree of appreciation than the more stretched valuations seen in the United States and other developed markets.
Finally, EM may also benefit from a falling U.S. dollar, as dollar strengthening/weakening trends have historically been multiyear in nature. As 2017 was the first year of dollar weakness after many years of dollar strengthening, we view the odds of continued weakening as good.
The global economic environment in 2018 should provide an ideal growth scenario for EM equities. However, as recent days have shown, the lack of volatility seen in this asset class during 2017 is unlikely to continue through 2018. Investors should re-confirm their risk tolerance now, as staying invested in times of sudden sharp losses will be key to success in 2018.
Enough is Enough: Why We Cap Country Exposure in Our Emerging Markets Strategies
Should you cap your exposure to China? We think so. We argue that the growing concentrations in many emerging markets indexes do not make a great deal of sense. Learn more about why we believe in maintaining country weight caps.
Why Downside Protection is So Powerful for Emerging Markets (EM) Investments
EM equities are risky, with elevated levels of political, currency and liquidity risk. Did you know that they also routinely experience large drawdowns? Every calendar year since 2001, this market drop has exceeded 10% even in strongly bullish years. Now that is volatility!
Potential Parametric Solution:
The Parametric Emerging Markets strategy is an all-cap equity strategy that includes large-, mid- and small-cap stocks in over 50 developing countries. The strategy invests across both emerging and frontier markets, and uses a top-down, three-part process designed to actively eliminate country and sector concentrations. We apply a disciplined, unemotional trading approach to build and maintain the strategy’s investment exposures.
Tim Atwill, Ph.D., CFA – Head of Investment Strategy
Mr. Atwill leads the Investment Strategy team at Parametric, which is responsible for all aspects of Parametric’s investment strategies. In addition, he holds investment responsibilities for Parametric’s emerging market and international equity strategies, as well as shared responsibility for the firm’s commodity strategy.
1The cyclically adjusted price-to-earnings (CAPE) ratio is a valuation measure that divides the current level of an index by an inflation-adjusted average of earnings over a historical time period. All of the above ratios are based on a 10-year observation window for earnings.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.