Research Affiliates' Rob Arnott: 3 reasons you should throw your hat into the emerging-markets' ring

Value, currency and momentum favor the category

Dec 19, 2016 @ 12:48 pm

By John Waggoner

Research Affiliates' CEO, Rob Arnott, thinks emerging markets are a hat trick: An unusual three-way combination of low valuations, depressed currencies and strong momentum.

Mr. Arnott first made his recommendation for emerging markets back in January, and the average diversified emerging markets fund has gained 7.8% this year, and 17.8% since the February 8 low. Those strong gains are no reason to give up on emerging markets, he said.

The Shiller price-to-earnings ratio is the basis for Mr. Arnott's valuation argument. Created by Yale economist and Nobel Prize winner Robert Shiller, the Shiller PE ratio uses average inflation-adjusted earnings from the previous 10 years, rather than one-year trailing or one-year forward estimated earnings.

By that measure, emerging markets were trading at 11.2 times earnings, below the 13 times earnings during the 2008 financial crisis.

At those levels, Mr. Arnott projects a 7.5% return after inflation over the next 10 years.

Valuations in emerging markets went from euphoria to despair from 2007 to 2016, Mr. Arnott said.

"The narrative shifted from where emerging markets were going to catch up with the developed market — it was just going to take time — to the diametric opposite by 2015,” he said.

And countries don't have to become wonderful to send markets soaring.

“Brazil had a nearly 80% move this year,” Mr. Arnott said. “Was it because they went from corruption to the rule of law? No. It was because they took baby steps from right to wrong.”

Buying into markets when they are trading at a Shiller PE of less than 10 has had an average total return of 120% five years later.

“That's pretty darn good,” Mr. Arnott said.

The strong dollar, which has bedeviled most international funds, is also a positive for emerging markets. An unusually strong dollar means unusually depressed emerging-markets' currencies. “Emerging-markets currencies tumbled from 25% above fair value in 2011 to 30% below fair value in January of this year,” Mr. Arnott wrote. “Even after this year's rebound, they remain about 19% cheap to the U.S. dollar.”

While currencies are notoriously difficult to predict, Mr. Arnott thinks emerging-markets currencies could continue to rise back up to fair value or beyond.

The final hat in the ring: momentum. Chasing performance is generally a losing tactic. But following trends — which has a sell discipline — can be a successful tactic, Mr. Arnott argues. Removing the emerging-markets' 2015 free fall from their 12-month records will strengthen their 12-month momentum signal.

The economic news out of emerging markets is probably the least positive part of the forecast. Mr. Arnott said his business cycle forecast shows a 54% chance of an economic slowdown. But slowdown risks are down considerably from their 2015 level of 67% — meaning that, while the forecast isn't great, it's less bad than it was.

“Given recent price and economic momentum, we are reasonably confident the bear market in EM assets — five years long for EM equities and currencies, and three years long for EM local currency bonds — came to an end in January 2016, and the early stages of a bull market look to be well underway,” Mr. Arnott wrote.

He is also bullish on emerging-markets bonds, which currently yield more than U.S. high-yield bonds. The big difference: “Half of emerging-markets bonds are investment grade,” Mr. Arnott said.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

May 02

Conference

Women Adviser Summit

The InvestmentNews Women Adviser Summit, a one-day workshop now held in four cities due to popular demand, is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.... Learn more

Featured video

INTV

Former CIA director John Brennan on the importance of contingency planning for financial advisers

Speaking from the floor of the MarketCounsel Summit in Miami, the ex-CIA director makes a strong case for why financial advisers need to have a plan for managing through a disaster.

Video Spotlight

Help Clients Be Prepared, Not Surprised

Sponsored by Prudential

Recommended Video

Path to growth

Latest news & opinion

Brace for steepest rate hikes since 2006 in new year

Citigroup, JPMorgan Chase predict average interest rates across advanced economies will climb to at least 1 percent in 2018.

Why private equity wants a piece of the RIA market

Several factors, including consolidation in the independent advice industry and PE's own growing mountain of cash, are fueling the zeal to invest.

Finra bars former UBS rep for private securities transactions

Regulator says Kenneth Tyrrell engaged in undisclosed trades worth $13 million.

Stripped of fat commissions, nontraded REIT sales tank

The "income, diversify and interest rate" pitch was never the main draw for brokers.

Morgan Stanley fires former Congressman Harold Ford for misconduct

Allegations against the wirehouse's former managing director include sexual harassment, which Ford denies.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print