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Emerging Market ETFs Defy Consensus

John Davi

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by John Davi, founder and chief investment officer of Astoria Portfolio Advisors in New York City. 

Going long the U.S. dollar was one of the biggest investing ideas heading into 2017. So much for that call. The U.S. dollar is down 9% year-to-date.

There has been a lot of talk over the flattening of the U.S. yield curve, and whether that might be signaling a deflationary scare. It seems quite unusual that global small-caps would be up 25% if markets were experiencing a deflationary scare. Emerging market equities, too, are up 25%. In our view, these are yet more signals that point to an accelerating global economy. 

What’s the biggest story in 2017? A good chunk of investors would argue that Trump’s inability to get legislation passed would be at or near the top of the list. However, purely from an investor’s perspective, the reality is that the biggest story is emerging market equities and global small-caps are this year’s market leaders.

So much for consensus ideas. 

Why Emerging Markets Are Working

The environment for emerging market equities is as attractive as it’s been in several years. Why? First, because of a weaker dollar—but also due to: low U.S. interest rates; loose financial conditions; and greater margin of safety compared to valuations for most of the developed world.

However, there are—and will continue to be—winners and losers within EM equities. India, in particular, has many attributes that makes it attractive on a short-term (six months) and on a long-term basis (one to two years) in our view. Think funds like WisdomTree’s India Earnings ETF (EPI), which we like in our multi-asset risk allocation model portfolio.

Specific to India, here’s what to consider:

  • The current earnings season is solid. Revenue and net profits are up 15% year-over-year and 10% year-over-year for the broader equity market.
  • Earnings: Consensus estimates project 13% and 19% earnings growth in 2017 and 2018, respectively.
  • Valuations: On a price-earnings basis, Indian equities are trading at a 15% premium to its long-run average. However, in the context of a risk-free rate, which is at a 20-27% discount to its long-run average, Indian equity valuations appear attractive.
  • Flow of Funds: With a booming middle class and a transition away from physical assets toward financial assets, domestic equity savings are projected to increase $400 billion to $500 billion in the next decade. This in particular is what makes India attractive on a secular long-term basis.

 

And So Much For China’s Hard Landing

The case for emerging markets, and particularly India, is a good example of the challenges of managing portfolios in a world that’s often driven by investors’ often-wrong consensus.

Remember when everyone was concerned about China’s hard landing? Right around the time there was a peak in “China hard landing” searches on Google is when the iShares MSCI Emerging Markets EEM ETF (EEM) reached its five-year low.

Since the height of “China slowdown” searches on Google, EEM is up 40%. I have always found that when the noise is the loudest, the risk/reward of investing is generally in your favor and worth leaning on. 

 

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When I first entered into this industry, I read a long list of investment books along with every single Warren Buffett annual newsletter. None of those books talked about game theory, which for me has increasingly become an important part of the investment management process.

In short, for game theory analysis, we are looking at a cross section of sentiment and positioning indicators to see where positons might be "offside."

Examples such as being long the U.S. dollar and predictions of a flattening yield curve at the beginning of the year are reasons Astoria Portfolio Advisors deploys game theory into our investment process, along with traditional valuation analysis and using quantitative risk modeling to identify key portfolio risks.

At the time of writing, Astoria Portfolio Advisors owned positions in EPI and IEMG. For a list of relevant disclosures, please click here.

 

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