Avidian Report – Emerging Markets Choppy But Still Make Sense In a Portfolio

INSIDE THIS EDITION:

Investors may have noticed recent turbulence in emerging market stocks. A great deal of this can be attributed to concerns about China’s decision to clamp down on specific sectors like education and technology, while more recently, the headline has been around Evergrande and what a default on their immense debt could mean for the Chinese economy.

At the same time, and perhaps unsurprisingly, MSCI Emerging Market shares have seen a negative technical picture develop, One where the largest number of companies in the MSCI Emerging Market Index have seen their moving average convergence-divergence (MACD) flip negative since January.

This has added to the outperformance we have seen for domestic equities as measured by the S&P 500 over their emerging market peers in the last decade.

However, it should be noted that this decade-long outperformance follows a period when emerging markets outperformed the S&P 500 by a wide margin. As investors, it is essential to recognize that this is, in fact, the nature of investing; certain geographies or asset classes will assume leadership after periods of disappointment and then will cede leadership to other geographies and asset classes.

This is part of the case for holding a globally diversified portfolio that includes emerging markets exposure.

Another argument for holding a globally diversified portfolio is that as these markets shift over time, and a patient investor can capitalize on pockets of tremendous opportunity, especially when there are meaningful price dislocations.

And there may be one occurring in some pockets of the natural resource and commodity sector, of which emerging markets have a disproportional share. Some of these sectors have already ticked higher and have led to some inflationary pressures in emerging markets and increases to monetary policy rates in certain countries, as shown below.

There is a possibility that some natural resource and commodity sectors see continued upward pressure on prices for at least a time, especially if reports of worker shortages in mining and the like remain in place.

We believe that despite challenging short-term news out of some parts of the emerging world, an allocation to these markets remains prudent for the long-term investor. Especially when we consider that there is currently a sizeable valuation discount attached to emerging markets relative to domestic equities. This is partly due to the lingering overhang COVID-19; when we look ahead, we believe that, eventually, emerging market equities will shine again just like they have at times in the past.

And even though the timing of this shift is impossible to predict, it is likely to occur at some point as valuations today greatly influence expected returns for the future. More specifically, lower valuations tend to indicate more attractive future returns than higher valuations do, and as the chart below clearly illustrates, the MSCI Emerging Markets Index is trading at a sizeable discount to the S&P 500 on a price/earnings basis.

Before closing this week’s report, we want to clarify that this does not suggest going drastically overweight emerging markets. Nor does it indicate that we are not constructive on domestic equities. Instead, we wanted to highlight the merits of maintaining an emerging markets allocation, including diversification and expanded opportunity set, despite some of the present-day risks: COVID-19, currency risks, and headline risk like we have seen regarding China as of late. And of course, investors should consider their exposure to emerging markets within the context of their entire portfolio and risk tolerance. 

Weekly Global Asset Class Performance

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