We recommend that investors gain exposure to emerging markets by buying units of the iShares Emerging Markets ETF (EEM), explains Elliott Gue, editor of Deep Dive Investing.
Broadly speaking, the emerging markets outperformed the S&P 500 from 2003 through 2010, underperformed sharply from 2010 until early 2016 and have performed more or less in line with the S&P 500 since early 2016.
A nascent recovery in EEM’s relative strength throughout 2017 was cut short last year amid a 6-month period of significant underperformance between April and October 2018. Equally important, the EEM has significantly outperformed the S&P 500 since late October of last year.
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There are 4 basic legs to our rationale for buying EEM right now:
#1: We’re Bullish on the S&P 500 in 2019
The first point to note here is that there is a strong correlation between returns in the S&P 500 and the Emerging Markets ETF. This history is logical.
After all, when the US market sees strong gains in a single trading year, it’s typically a sign that investors are in a “risk-on” mood and willing to venture into more volatile emerging market stocks. Similarly, in negative years such as 2008 investors are in a risk-off mood and typically favor the safety of developed market stock indexes.
We remain bullish on the S&P 500 in 2019. We do not believe the US economy is headed for recession nor do we see the S&P 500 entering a recessionary bear market.
The single most important rationale for buying EEM here is that emerging markets tend to outperform the S&P 500 in years when the S&P 500 produces strong returns. Over the past 20 years, EEM has outperformed the S&P 500 by an average margin of more than 16% in the 8 years when the S&P 500 is up by more than 15%.
#2: We’re Bearish on the US dollar in 2019
Emerging markets tend to outperform when the US dollar is weak. Our analysis of the past 20 years of data suggests that a combination of a weaker US dollar and positive market returns for the S&P 500 adds up to a powerful driver of emerging markets outperformance.
Of course, the dollar was strong in 2018; that’s been a headwind for the emerging markets over the past 12 months; however, we believe the US dollar is more likely to fall that to rise in 2019 for a few reasons.
First, it’s unlikely US interest rates (or real interest rates) will rise as much in 2019 as was the case in the first 11 months of 2018. Thus, this key tailwind for the dollar is set to abate in 2019 or, potentially, turn into a modest headwind for the greenback.
Second, last year the US economy was a bright spot: US economic growth accelerated while economic growth in the Eurozone slumped and growth in China appeared to decelerate sharply, especially in the second half of 2018. In 2019, we see this tailwind for the dollar fading. That’s because US economic growth appears to be slowing somewhat from a strong pace in 2018.
#3: The Chinese Economy is Likely to Gain Steam in 2019
As I just noted, Chinese economic growth decelerated after the middle of 2018 for a number of reasons including the threat of a trade war with the US.
However, we believe the US and China are likely to conclude a trade deal in early 2019. Already, China appears to be making concessions to the US on trade, proposing a plan to reduce its trade surplus with the US over the next few years. We also believe the Trump Administration will be eager to conclude a trade deal and has used tariffs as a bargaining chip to extract concessions from China.
It’s also worth noting that the Chinese government is taking significant steps to stimulate economic growth in 2019. We suspect these fiscal and monetary stimulus measures in China will begin to shore up economic growth in 2019 and fears that China could see a more serious slowdown in growth — to less than 5% annualized in 2019 — will prove unfounded.
A trade deal with the US would further help to support China’s fundamentals and sentiment surrounding the market. China accounts for more than 26% of the assets in the EEM exchange-traded fund so, if economic growth picks up as we expect, that will represent a sizable tailwind for EEM.
#4: Emerging Markets Look Cheap on an Absolute and Relative Basis
Over the past 12 years, the MSCI Emerging Markets Index has traded at an average forward price-to-earnings ratio of about 12 times though it rose to over 14 times earnings in late 2017. That marked the highest valuation on this basis since 2010, when earnings were depressed in the aftermath of the 2007-09 Great Recession and financial crisis.
Valuations alone are never a great reason to invest in any market; however, emerging markets looked a bit expensive in late 2017 and are now looking much more reasonable valued. Another way to look at this is that EM stocks were pricing in strong growth in late 2017 but expectations are more muted today, leaving scope for strong gains should EM growth surprise to the upside this year.
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