Let’s begin an emerging markets thesis by reviewing recent history in EM space as measured by the MSCI Emerging Markets Index:
The top half of this chart is the iShares MSCI Emerging Markets index (we use the ETF EEM) going back to late 2006. Superimposed (in black) behind is the S&P 500 index. Below is a rolling 40 week correlation between the MSCI Emerging Markets index and the Continuous Commodity Index (a basket of cash commodities i.e. unaffected by futures contract roll or collateral yield).
Let’s pick up the story during the financial crisis of 2008.
- From May to December 2008 – EEM fell a gut wrenching 50% peak to trough (S&P 500 was -37.6% during the same period).
- The rebound from the 2009 lows was a lot swifter in emerging markets with EEM regaining its 2007 highs in April 2011 while the S&P 500 only regained its highs 2 years later in April 2013. We offer a few explanations for this:
- Emerging markets had lower debt levels than developed markets and were perceived as ‘safer’ bets going forward – giving rise to the spectacular rally in Emerging Market Debt.
- Fed supplied stimulus Dollars found their way into faster growing economies and markets.
- Simple momentum, what’s goes down further will rebound quicker.
Then in Fall of 2011 (excuse the pun) the European Sovereign crisis erupted (red arrow). Emerging markets encountered a fair bit of selling as the contagion spread.
The old colonial lines are very much alive and well. Europe colonized the emerging markets in the 18th and 19th century and although the colonial masters left a longtime ago, those credit lines still exist today as does established trade routes, making Europe a very important customer for emerging markets. Bringing us to a market truism we live by – if you perceive an economic thread exists, don’t wait until it gets pulled, assume it’s there and manage your risk accordingly. Fire first and ask questions later, no matter how illogical the premise.
In late May 2013 (blue arrow), then chairman Ben Bernanke, started discussing publicly the prospect of reducing the $85B monthly bond purchase program… QEInfinity. Interest rates the world over rushed higher. We had seen this movie before, the price of EM debt which had been the beneficiary of tremendous flow up until then reversed violently lower and probably took EM equities down with it. Where money flows pain will ultimately go!
Since May 2013 EEM has recovered some but underperformed the US markets. Giving rise to heated discussions in investment shops over whether the EM world is really multifaceted (which it is).
Proponents recommended buying select EM markets over others – Mexico being a recent favorite. This article on CNBC captures the mood.
What we really think is happening is that those EM markets that were strongly correlated to the commodity cycle (particularly as producers) have lagged versus their peers and dragged EEM down versus the S&P 500. For EEM to begin outperforming we would need to see a rebound in raw materials demand from:
- A rebound in the Chinese economy (China is in a debt crisis – unlikely)
- inflation concerns picking up due to US growth (US Treasuries are saying no)
- Or our least favorite but seemingly most likely – War!
Have a great week!
Greg Silberman CFA®, CAIA, CA(SA)
Chief Investment Officer
Advisory Services offered through Atlanta Capital Group.
Securities offered through Triad Advisors, Member FINRA / SIPC
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