For what feels like an eternity, market pundits have been calling for the “great rotation” from bonds to stocks. A rotation is happening, but elsewhere.
The problem with the bonds-to-stocks rotation is that outside of a couple of head-fakes, borrowing rates have remained stubbornly low.
All the while, investors have indeed been reallocating, but in perhaps a different manner than most had anticipated; namely, out of emerging markets equities and into their developed market counterparts.
On the other hand, the Vanguard FTSE Developed Markets ETF (VEA), the PowerShares QQQ Trust (QQQ), the SPDR S'P 500 ETF (SPY) and the iShares MSCI EAFE ETF (EFA) have collectively seen more than $13 billion in inflows over the first seven-plus months of the year.
This dichotomy speaks to a shift not just in assets, but also in the global economy.
As our own Matt Hougan recently pointed out , the total market segment of the emerging markets space has been extremely weak in 2013. The iShares Core MSCI Emerging Markets ETF (IEMG) that tracks perhaps the most comprehensive emerging markets index—the MSCI Emerging Markets IMI—has fallen more than 9 percent this year.
A combination of monetary tightening measures in China; civil unrest in Turkey and Brazil; and economic restructuring has made the developing world less appealing relative to the developed world—regardless of the fiscal challenges facing the latter.
Call it the cleanest-dirty-shirt dynamic.
While it may seem easy to pick apart the logic of transitioning assets to developed equities markets, the fact is that U.S. equities and the iShares MSCI EAFE ETF (EFA) are both up this year, and even the iShares MSCI EMU ETF (EZU) is quietly up 3 percent year-to-date, while emerging markets sit well in the red.
Meanwhile, the IMF recently cut its growth forecast for emerging markets—along with the rest of the world—citing, among other things, a negative outlook for exports.
To that end, the inability of emerging markets to grow and maintain exports in a world where nearly all central banks are openly debasing their currencies poses perhaps the biggest obstacle and opportunity for these markets.
On the one hand, so much of the developing world’s returns over the past decade have been fueled by resource and manufacturing exports.
Any sustained weakness in export markets should therefore have a massive impact on the profitability of the key firms in these markets. Moreover, increasing energy independence and efficiency in the developed world threatens to further erode large pockets of these economies.
On the other hand, a massive amount of policy and capital has been dedicated to fostering a new, domestic demand-dependent economic model in these countries, and we may be seeing a paradigm shift in the way emerging market economies grow.
Friday’s announcement of a policy shift in Beijing aimed at liberalizing corporate lending laws is the most recent example of how elected officials are trying to redirect resources to consumer-driven sectors of the economy.
If we are indeed seeing this type of economic restructuring, it bodes well for the future of the emerging markets even if it does not necessarily portend short-term gains.
After all, a transition of this scale—exports still represent 30 percent of China’s GDP—won’t happen overnight. The current economic powerhouses in the emerging markets—basic materials, energy and financial firms—will become incrementally smaller pieces of the economic pie.
As that happens, some of the sectors that serve consumers, like those found in the EGShares Emerging Markets Consumer ETF (ECON), may indeed outperform. That is quite possibly what we’re seeing now.
But it bears mentioning that the developed world will still have a big role to play in this shift.
The fact is that many of the largest consumer firms in the world are domiciled in the developed world. These are the firms with the size and scale now to profit from increased discretionary spending in the emerging world.
It’s these sometimes-complimentary and sometimes-competing forces that investors weighing the emerging-versus-developed debate have had to wrestle with.
Given the current landscape, we could continue to see investors have a marked bias to the developed world, at least until the emerging markets can prove them wrong.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at firstname.lastname@example.org.
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