Over the past few years, there can be no denying that investors in Emerging Market equities have been left with a bad taste in their mouth. Since the start of 2011, the Emerging Market ETF has returned minus 15% while the S&P 500 has risen by over 60% in this same period.
Emerging markets are more sensitive to changes in global economic growth than the more mature developed markets. They also have more exposure to commodities which are dependant on an expanding economy. Therefore given the collapse in the global economic growth rate over the past few years, it is no surprise that Emerging Markets have suffered.
The emerging markets are also more dependant on US dollar liquidity as these companies are more apt to borrow in US dollars. This has made the recent US dollar rise all the more painful for these companies. Not only has the US being withdrawing liquidity with the wind down of QE and the subsequent preparing for an eventual interest rate hike, but the US dollar rise has been increasing the emerging markets companies’ liabilities.
During this period US equities have been on a tear upwards. Although at the start of 2011, US equities were attractively priced versus other world markets, at this point the discount has turned into a premium. Investors have simply been chasing the market that has been going up while ignoring the others.
The idea that the US is the “cleanest shirt in the dirty laundry pile” is such a worn out theme that there is little chance it will continue to work. The consensus that the global economic slowdown will continue and that the US will be able to outperform is fully baked in.
I would argue that both points will prove incorrect in the months to come. Economic growth is poised to bottom and that during the move upwards, US markets will under perform.
Since the 2008 credit crisis, the Federal Reserve has been one of the most aggressive Central Banks when it comes to balance sheet expansion. Apart from the Bank of Japan, they have been the most accommodative. While at first, the Quantitative Easing seemed to be woefully impotent, the fact that the US is now one of the best performing major economies has changed the narrative. Meanwhile countries reluctant to engage in balance sheet expansion have found themselves mired in a deflationary funk.
As the US economy has recovered the Federal Reserve has stopped their Quantitative Easing and is attempting to prepare the market for an eventual interest rate hike. This withdrawal of liquidity has been one of the main factors in the recent global economic slump. The world had unfortunately become much too dependant on the US dollar liquidity.
The response has been slow, but the rest of the world has finally picked up the baton from the Federal Reserve. Over the past few months, nine prominent Central Banks have cut rates or expanded their quantitative easing. Every time you turn around there is another Central Bank surprising the market. Just yesterday it was the Reserve Bank of Australia, last week it was the Bank of Canada, and this morning even the Bank of China has jumped into the action by cutting the reserve ratio.
Central Banks are panicking about the deflationary slump that has engulfed the global economy. As they continue to ease the world economy will respond. When it does, Emerging Markets are going to fly.
Emerging Markets are under owned and left for dead. Don’t chase the US market on the expectation that an uptick in the global economy will send American stocks soaring. Although the Federal Reserve might ease off their hawkish stance, at the margin they will not be one of the more expansionary Central Banks out there. They will continue to be relatively tight as compared to other Central Banks. US stocks are set for years of under performance.
Recently the market has been giving you a few hints that the global economic downturn has run its course. Copper has stopped declining.
Same deal with crude oil.
I also think that over the short run, the US economy has been suffering from the US dollar rise. The Federal Reserve will soon ease up on its hawkish rhetoric. Yet speculators are still long US dollars out the whazoo.
I think an interim top in the US dollar was made at the end of January. I suspect that this overly crowded trade will experience a big correction in the coming weeks. This will at the margin also be beneficial for Emerging Market equities.
I have been loading up on EEM call options. I am still scared about a financial accident, so I think that limiting your exposure through options makes sense. But I think that Emerging Markets are a table pounding buy down here – especially relative to the US stock market.