Are emerging markets the place to be when US stocks drop?

They are cheap, but no panacea during a serious downturn

May 24, 2017 @ 12:13 pm

By John Waggoner

Editor's note: This is part of a series looking at how the advice industry is getting ready for the next market correction.

If you've ever bought a refurbished fire extinguisher from Frank's Firefighting Warehouse ("Where every sale is a fire sale!"), you know that buying cheap doesn't always mean getting a bargain. And that might be true for some emerging markets — but not all.

After nearly a decade of underperformance, emerging markets are historically cheap. The MSCI Emerging Markets Index currently sells for 15.2 times its past 12 months' earnings, versus 22.3 times earnings for the Standard and Poor's 500 stock index. In a market this pricy, it would seem to make sense to move some assets to a cheaper spot.

And over the long term — 10 years or so — that's a strategy that makes some sense. It's better to buy stocks when they're cheap, relative to earnings.

But if you're backing up the truck because you think emerging markets will suffer less in a downturn than U.S. stocks, you might want to glance at history.

(More: Is Dow Theory signaling a market downturn?)

In the last bear market, during the Great Recession, the Vanguard 500 Index Investor fund (VFINX) swooned 55%. The Vanguard Emerging Markets Stock Index fund (VEIEX) tumbled 61%. The two funds currently have a three-year r-squared of 80, meaning their returns are highly correlated.

"On a relative basis, we find emerging markets very attractive," said Arjun Jayaraman, co-manager of Causeway Emerging Markets (CEMIX). "But emerging markets are a high beta asset class, and they will lose more money on average if the markets are down globally."

Put another way: "If Germany or Brazil go into recession, the U.S. can be fine," said James Swanson, chief investment strategist at MFS. "But not the reverse."

Still, emerging markets are wildly diverse, and a touch of discrimination can go a long way.

"The key is, don't buy the index," said Laurence Taylor, portfolio strategist at T. Rowe Price.

One reason emerging markets have appeared homogeneous is because of the commodity supercycle, Mr. Taylor said. Countries like Brazil and Russia fed the enormous demand coming from China. But that period has ended.

"We believe the commodity supercycle is unequivocally over," Mr. Taylor said. "China is no longer an incremental buyer of commodities."

For that reason, emerging markets are showing vast disparities in returns and growth characteristics.

For example, the cheapest emerging markets, Russia and Turkey, are exceptionally cheap. Unfortunately, they deserve to be: Corporate profitability is low and declining in both countries.

Making things worse: "They have significant corporate and political governance issues as well," Mr. Taylor said. The top-performing emerging markets — India and Mexico — aren't cheap, but they're profitable and growing, Mr. Taylor said.

And if you look at individual markets weighted equally, you'll see that valuations aren't quite as cheap as they appear, said Sammy Simnegar, manager of Fidelity Emerging Markets fund (FEMKX). Simnegar, who uses forward earnings estimates, notes that several emerging markets are more expensive than the U.S.

"If you look at the median emerging-market PE, you'll see it's not that much cheaper than the U.S.," he said.

The bright spot, however, is that emerging markets tend to rebound more quickly after a global recession. (Oddly, the Japanese market rebounds more quickly.) The difficulty is figuring out when, exactly, that happens.

Advisers have a few choices:

• Dollar-cost average into emerging markets over a relatively long period of time. Clients won't get in at the bottom, but they won't get in at the top, either. "Sometimes you get three years' worth of growth in six to 12 months," Mr. Simnegar said.

• Consider a rules-driven fund that seeks to limit damage in a downturn. SPDR MSCI Emerging Markets StrategicFactors ETF (QEMM), for example, looks for high-quality, low-volatility emerging-markets stocks with sustainable cash flow.

• Look at how emerging-markets funds performed in the last bear market. While no two bear markets are alike, you can get some idea of management skill in a wretched market by looking at the 2007-09 meltdown. Aberdeen Emerging Markets (ABEMX) was the top performing emerging-markets fund during the big bear market, falling 38.7% from peak to trough. Matthews Asia Growth & Income Investor (MACSX), while not strictly an emerging-markets fund, fell 29.3% in the Great Recession.

• Consider large multinational stocks, such as Unilever or Nestle, that have much of their revenue from emerging markets. You'll get exposure to those markets, but with a somewhat smoother ride.

Emerging markets are relatively cheap in a universe of expensive stocks. But cheap can always get cheaper. While emerging markets may seem tempting, be sure you and your client understand the risks they engender.

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