Emerging-Market Rally Has Further to Run

Author: Bill Witherell, Ph.D., Post Date: August 25, 2017

Emerging market equities are continuing to outperform remarkably this year. While a pullback seems overdue, there are a number of reasons to expect the trend to remain upward, perhaps for several years more. The iShares MSCI Emerging Markets ETF, EEM, is up 28.19% year-to-date August 24. The Vanguard FTSE Emerging Markets ETF, VWO, has gained somewhat less, 23.48%. The main reason for the difference is that VWO tracks an index that excludes South Korea, considering that country to have gained developed-country status, whereas the index tracked by EEM includes South Korea with a significant weight, 15.55%. Despite the geopolitical risk on the Korean peninsula, the iShares MSCI South Korea Capped ETF, EWY, has registered a gain of 29.37% year-to-date. The above gains compare favorably with the year-to-date gains of the global iShares MSCI All Countries ETF, ACWI, 14.14%, the iShares MSCI All Countries ex US ETF, ACWX, 18.59%, and the US market as measured by the SPDR S&P 500 ETF, SPY, 10.16%. All returns are on a total return basis.

The macroeconomic underpinnings of the equity market rally in emerging-market economies are strong. In its July 2017 World Economic Outlook, the IMF projects the growth of emerging-market and developing economies, measured as real GDP, to be 4.6% this year and 4.8% in 2018, compared with 4.3% in 2016. These calculations are dominated by the emerging-market economies, which are much larger than the developing economies. Indeed, the OECD’s June Economic Outlook includes growth estimates for 2017 and 2018 of 4.6% and 4.8% for the seven G20 countries that are not members of the OECD (Argentina, Brazil, China, India, Indonesia, Russia, South Africa, and Turkey).

China’s economy is expected to slow slightly in 2018, from 6.7% growth to 6.4%, due to a carefully managed monetary tightening designed to restrict non-bank lending through China’s “shadow” financial system. Offsetting this, the economies of India, Indonesia, Brazil, Argentina, Russia, South Africa, along with those of the OECD members Korea, Chile, and Mexico, are expected to register stronger growth next year.

Emerging-market economies have become stronger structurally over the past several years. Their exchange rates have become more flexible, thereby making the economies more resilient to external shocks. Levels of foreign exchange debt and current account deficits are lower, while foreign exchange reserves are higher. Reforms in India, China, and Indonesia have moved in the direction of better balancing those economies, while Brazil’s reforms are still very much a work in progress. Conditions for commodity exporters are gradually improving. The main risks to this positive outlook are adverse geopolitical developments, extended policy uncertainty in the US, Brexit-related developments in Europe, increased protectionism that impacts trade and global supply chains, and a more rapid than expected moderation of central bank stimulus.

The latest leading indicators are sending a mixed message. OECD’s Composite Leading Indicators for June, published August 8th, indicate “growth gaining momentum” for China and Brazil, “stable growth momentum” for India, and “tentative signs of easing growth” for Russia. The Caixin China Composite PMI Output Index for July also showed an improvement, reaching a four-month high at 51.9, while the PMI for Russia sank to a ten-month low. India’s PMI declined sharply, apparently due to a new sales tax, and Brazil’s PMI continued to show contraction (a reading below 50%).

Emerging-market valuations continue to have an edge over those of the developed markets, despite the price increases that have been registered. The price-to-book ratio for MSCI EM equities is 1.66, still below the long-run average of 1.8. Their price-to-earnings ratio is 16.06, compared to its average of 24.2 and those of developed markets (24.11 for the S&P 500 ETF, SPY, and 23.59 for the iShares MSCI Eurozone ETF, EZU).  Along with the positive growth outlook summarized above, an important reason for expecting this emerging-market rally to continue is that these markets are still recovering from their lows of early 2016.

We are favoring the Asia-Pacific and Latin American emerging markets in our International Portfolio. Together they account for 84% of the MSCI EM equity index, with Asia-Pacific and its very large equity markets alone amounting to over 72.6% of this capital-weighted measure. The iShares MSCI Emerging Markets Asia ETF, EEMA, is up 32.66% year-to date August 24. Within that region the iShares MSCI China ETF, MCHI, is up 41.27%. Even more remarkable, the PowerShares Golden Dragon China Portfolio ETF, PGJ, has gained 50.42% so far this year. It invests solely in US-listed companies that derive a majority of their revenues in China. This means its holdings are mainly in internet software and services, internet and direct marketing retail, and education services and not in the large banks found in other China large-cap ETFs. India also is an important market in the region. Its reform-oriented government is making much needed changes. The iShares MSCI India ETF, INDA, has gained 26.90% year-to-date.

The Latin America region’s equity markets are dominated by those of Brazil, Mexico, and Chile. The iShares Latin America 40 ETF, ILF, which tracks an index of 40 of the largest firms in the region, is up 27.26%. While the ETF for the largest LA equity market , the iShares MSCI Brazil Capped, EWZ, has gained a more modest 21.89% as the Brazilian economy slowly recovers from recession and continues to experience political turmoil, Mexico’s equity market, despite the threats from Trump, continues to impress, with the iShares MSCI Mexico Capped ETF, EWW, bouncing 31.73% so far this year. The smaller but robust Chilean market is rebounding from its June pullback, with the iShares MSCI Chile Capped ETF, ECH, still managing a 28.50% gain for the year to date.

Outside these two regions we are watching with interest the steady gains of the Polish market, as the Polish economy profits from its close relations with the Eurozone’s powerhouse, Germany. The iShares MSCI Poland Capped ETF, EPOL, is up an impressive 46.58% year-to-date.

In sum, equity investors who were positioned in the emerging markets at the beginning of 2017 should be seeing very attractive gains thus far this year. There are reasons to think this rally may still have some legs. Market pullbacks, therefore, may provide entry points. The historically higher volatility of these markets and their vulnerability to “risk-off” market swings should be kept in mind.

Sources: Ned Davis Research; ETF.com; IMF World Economic Outlook Update, July 24, 2017; OECD Composite Leading Indicators news release, August 8, 2017; OECD Economic Outlook, June 2017; Goldman Sachs Economic Research; Oxford Economics; the Financial Times; and markit.com/commentary/economics.

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