The Cautious Case For Emerging Markets by STA Wealth Management
- If major central banks really are acting collectively to contain the trade weighted US dollar, then it just may be enough to put some kind of floor beneath dollar-sensitive commodity markets and stabilize global economic growth for the foreseeable future.
- In such a scenario, we believe politically-stable, yet beaten-up emerging markets stand to benefit from more accommodative monetary policy, improving economic activity, and a return of capital flows from the developed world.
- It’s worth noting that emerging markets are not a uniform group, but they do tend to move together in times of crisis. These kinds of exodus events can lead to attractive long-term return opportunities for patient investors.
- While investors may benefit from holding broad-based emerging markets exposure, we believe politically stable countries like Mexico, Indonesia, and the Philippines have the potential to outperform the broader basket over time for a number of country-specific reasons.
Emerging from Hibernation
If you’ve followed my work with Mauldin Economics (“A Scary Story for Emerging Markets” & “On the Verge of a Disaster… Or a Miracle”) and Evergreen GaveKal (“Here We Go (Down) Again”), then you know I’ve been bearish on emerging markets for the past few years.
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Although emerging economies accounted for the majority of global growth in the early years of the post-2008 recovery, they did so by accumulating high levels of debt and by expanding capacity in commodity markets now plagued by insufficient demand.
With that in mind, it should come as no surprise that years of easy money would eventually give way to tightening financial conditions, that years of robust commodity demand would eventually give way to oversupply, and that yield-seeking investors would eventually flee back to the “safety” of US assets when the Fed set a course for higher interest rates.
Although the selling pressure still has not boiled over into full blown contagion like the Latin American debt crisis in the 1980s, the Mexican Tequila Crisis in 1994, or the Asian Contagion in 1997, we have seen a cascading collapse in emerging market currencies over the last five years with poor returns for dollar-based equity investors punctuated by a series of panic attacks and short-lived reflations.
Contrary to what you might expect, weaker currencies have not bolstered emerging market growth rates. In fact, it’s had the opposite effect in many countries as central banks had to raise interest rates in the face of slowing growth to limit capital outflows and forestall widespread defaults on dollar-denominated debts. The results have ranged between modest drags on economic growth in places like India and Indonesia, painful slowdowns in places like South Africa and Mexico, and excruciating recessions in places like Brazil and Russia.
To be fair, it’s difficult to lump every developing economy together and talk about them as a cohesive group. While most investors tend to access these markets through pooled investment vehicles like ETFs and mutual funds – which often become forced sellers in times of risk aversion – not all emerging markets are made in the same image.
Commodity exporters like Saudi Arabia have very little in common with low-cost manufacturing nations like Vietnam or increasingly service-oriented economies like the Philippines… except that they tend to correlate strongly in periods of panic because Western investors often think of emerging markets as a single asset class.
Though otherwise good assets and relatively promising economies can get sucked into the contagion when investors rush for the exits, these kinds of exodus events can lead to attractive long-term opportunities for patient investors who understand the differences between precious “babies” and dirty “bathwater.”
Now that valuations are trading at depressed levels not seen since the bottom of the global financial crisis, it doesn’t take much more than marginal improvement in global commodity prices and/or a weaker US dollar to support a broad-based reflation in local currency emerging market equities and set the stage for an ongoing beauty contest as the most attractive markets rise to the top.
Since I believe that is precisely where we stand today, it’s time for this bear to cautiously come out from a long hibernation.
Emerging Markets – Cautious Optimism
As I explained in the last two STA Market Reports (“Did Central Bankers Just Save the World?” & “You Can’t Blame Them for Trying”), I believe emerging markets – along with the rest of the global economy – were headed for an earth-shaking crisis earlier this year.
Make no mistake. The sell-off in January and February was no simple correction. With the trade weighted US dollar on the edge of a major breakout & accelerating capital outflows rapidly depleting Beijing’s foreign exchange reserves, the odds of a disorderly drop in China’s currency were uncomfortably high and rising.
Amid those dual risks, Goldman Sachs called the unfolding emerging markets bust “the third wave of the global financial crisis.” I think that’s an apt description considering how closely G-4 central banks (US, Eurozone, Japan, & China) were flirting with mutually assured destruction before meeting on the sidelines of February’s G-20 gathering of central bankers and finance ministers in Shanghai.
In fact, I think we may have come as close to a global shock as the near break-up of the Eurozone in 2012. But just as it seemed a global crisis was unavoidable, everything changed and risk assets rallied across the board.
What looked at first like simple short-covering from oversold territory started to look more and more like a coordinated effort to set the world on a different course, much like the Plaza Accord in 1985 but in a quieter, subtler way.
“Everyone at the G20 table realized that monetary policies involving a currency devaluation by the Europeans and Japanese, or monetary policies involving currency appreciation by the US, would be counterproductive,” says Jeffries’ Chief Market Strategist and former Fed insider David Zervos. Instead of a currency war going nuclear, it appears we’re getting a fragile truce combined with a fresh dose of fiscal stimulus in China and Japan.
That’s the cautious case for emerging markets.
If we really are seeing major central banks act collectively to (1) weaken (or at least contain) the trade weighted US dollar, (2) stem capital outflows from China, and (3) stimulate credit growth in Europe, then it just may be enough to (4) put some kind of floor beneath dollar-sensitive commodity markets and (5) stabilize global growth for the foreseeable future.
Keep Calm & Carry On
Without major reforms around the world, I can’t say this next chapter will be all that exciting in terms of global growth. But positive signs are already starting to shine through all the negative Q1 economic data both in the United States and across the emerging world.
With the latest ISM manufacturing and non-manufacturing releases signaling a re-acceleration in US real GDP growth, the risk of a US recession dragging the rest of the world down with it may be receding. And while a modest improvement in US economic activity may push inflation higher in the coming quarters, Federal Reserve Chairwoman Janet Yellen has made it pretty clear that she’s willing to let the economy run hot in an effort to tiptoe around the risks posed by the strong US dollar.
It’s a healthy combination for emerging markets that promises to support both trade and capital flows as long as the Fed remains accommodative, the US dollar remains in check, and conditions actually start to improve across the emerging world as domestic central banks shift toward more accommodative policies.
As you can see in the chart below, that scenario is looking more probable as emerging market manufacturing activity is back in expansion mode for the first time in almost a year as the US dollar weakens, commodity prices start to firm, and the emerging market carry trade broadly resumes.
Again, it’s a bit early to make bold predictions about the future direction of global growth, but the range of probable outcomes is becoming more balanced with the looming risk of trouble in Europe or Japan should the US dollar weaken too quickly or too extensively. For now, it appears that the US dollar is fairly limited on the upside with a handful of reasons to believe it could weaken in the coming quarters. And in either event, emerging markets could be among the biggest beneficiaries as more favorable macro conditions intersect with depressed valuations.
While my colleagues and I on the STA investment committee have already added some broad emerging markets exposure in the last week to take advantage of a possible reflation as the year marches on, we are also taking a more targeted approach to grow the allocation by focusing on politically stable markets like Mexico, Indonesia, and the Philippines. We believe these markets are driven by different risk factors that we believe are capable of outperforming the broader basket.
To be clear, this is not a pound-the-table, bet-the-farm kind of investment; but we do believe a targeted allocation to emerging markets may provide attractive long-term returns at current valuations as these markets start to stabilize, capital flows return, and an upside scenario starts to materialize.
Chief Economist & Global Macro Strategist
STA Wealth Management
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