The International Active EAFE Strategy underperformed the MSCI EAFE index by 1.7 percentage points in the first quarter; the strategy fell 1.0% net of fees and the benchmark rose 0.7%. Negative stock selection was somewhat offset by positive country selection.
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GMO: Region Commentary
Perhaps the most disappointing asset class of the past few years has been emerging market equities, which was a splash of cold water for those hoping this 15-year market darling would provide solid performance relative to stocks in the slow-growing, post-crisis West. Indeed, since the end of 2012, the MSCI Emerging Markets index has underperformed its developed market peer, the MSCI World, by 24.5% annualized. While some smaller markets within emerging have performed fairly well over this time period, the malaise has been broad-based, and some of the larger countries, such as the much-hyped BRIC markets, have fallen the most. This is a startling contrast to the 13.6% per year outperformance that EM equities afforded over their developed market peers for the decade from 2001 through 2010.
Frustratingly, the recent underperformance occurred at a time when it is hardly clear that emerging market equities were expensive. The GMO 7-year asset class forecasts have consistently placed emerging markets near the top of their expected return ranking during this period. What happened and what do we think going forward? To understand where we are, we must go back to the catastrophic end of the last emerging markets cycle in 1998, when overheated emerging economies fell victim to capital flight, deflationary recessions, and currency devaluations. While the economic dislocation was severe, the equity and currency falls combined with internal restructuring left most of these economies extremely competitive and priced to outperform by the time the world started to recover from the TMT bubble. The September 30, 2003 GMO 7-year forecasts put returns for emerging equity at 6.9% real,1 and the MSCI Emerging Markets index returned 18.9% per year over the next 7 years. Value was obvious, and it more than delivered.
We would argue that the initial upturn in emerging market economies, from 2003 through perhaps 2007, was on sound footing. From that point onwards, however, a confluence of events created the conditions for an unsustainable increase in economic activity and equity market valuations, although conditions varied from country to country. One major feature of emerging markets, particularly those in Asia, is their tendency to manipulate exchange rates and accumulate foreign exchange reserves.
This boosts domestic money supply and underpins the inflationary boom that is the hallmark of the emerging market economic and credit cycle. The weak U.S. dollar throughout the first part of the last decade provided fertile soil for this cycle to assert itself once more. This pattern, however, was put into overdrive by two factors. One was the China bubble, which put upward pressure on commodity prices and significantly improved the terms of trade for emerging economies like Russia (oil), Brazil (iron ore), and Indonesia (palm oil and coal), to name a few. The second was unconventional monetary policy in the West after its financial crisis. These policies caused a global search for investment yield, commonly in the form of carry trades. Both of these trends forced huge amounts of capital into emerging markets, and this predictably inflated local economies, boosted exchange rates, goosed economic growth rates, and pushed equity and debt valuations to nosebleed levels. It is the reversal of these two factors that is responsible for the recent downturn in emerging markets, and there is ample reason to believe it could continue.
GMO has written at length on the Chinese economy and the issues that we believe exist there. In short, we believe that an epic credit bubble is in the early stages of unwinding. If we are right, there should be major downward pressure on industrial commodity prices in particular, negatively affecting the economies of the many emerging market exporters.