After six cumulative years of lagging returns versus the MSCI World, MSCI EAFE and the S&P 500 Indices, one might ask, why bother with emerging markets? What will break the spell and reverse the post-2007 overall period of underperformance? Emerging markets equities have certainly cracked from a valuation perspective and trade at a price-to-earnings ratio over 30% lower than developed markets – the largest valuation gap since mid-2005. Some of the performance drag reflects a loss of investor confidence, as several emerging markets are burdened by economic and/or political setbacks. However, the current economic travails of many emerging markets are not unusual. These countries have spawned domestic private and public sector credit excesses in prior cycles, leading to substantial – albeit temporary - market volatility. Political tensions, such as the recent conflict in the Ukraine, are typically buying opportunities, not reasons to abandon the asset class.
Despite the recent outflow of funds from emerging markets, Causeway currently favors an increasingly larger allocation to the asset class in its global opportunities strategy. We use the MSCI All Country World Index, with its 10% emerging markets weight as a starting point. In a global context, Causeway's allocation model favors emerging markets as a result of attractive relative valuation and earnings growth characteristics versus developed markets, improving macroeconomic factors and the rising level of global risk aversion (measured by the CBOE Volatility Index (VIX) and the emerging market bond index yield spread over US Treasury bonds). Admittedly, we are adding emerging markets exposure very gradually to client portfolios in our global and international opportunities strategies. Due to the importance of the "top-down" asset allocation decision, we must answer the following questions: How much of the decline in relative real gross domestic product (GDP) growth rates (emerging versus developed markets) is cyclical versus structural? To what degree can we rely on historical valuations of these markets– especially if structural changes are occurring?
Emerging markets achieved their best performance on record from 2002-2007 when the MSCI Emerging Markets Index rose by a cumulative 361%. The developing regions boasted improving external and fiscal balances, as well as rapid growth in sales and earnings.
Since then, imbalances have widened again for several emerging countries due to rapid credit-fueled domestic demand growth and weak domestic demand in the United States, Europe and Japan. As the overall trade surplus in the developing countries has fallen, much of the emerging bloc has receded into current account deficit (importing more than they export), with a few countries suffering from serious external imbalances (Turkey, South Africa, Brazil, and India, for example). To add insult to injury, foreign investors aren't waiting to see how it all pans out. When investors get nervous, they run for the exits. Emerging markets are paying the price for exchange traded fund (ETF) liquidity—suffering volatility inflamed by the ability of investors to sell ETFs quickly. Of the 22% drop in the net assets of the iShares MSCI Emerging Markets ETF in 2014 to date, only 6.5% is due to the total return of the fund. Outflows explain the bulk of the shrinkage in net asset value. We estimate that two prominent emerging markets ETFs lost $25 billion—more than 20% of their net assets—to outflows in 2013 and this year to date, combined.
To explore the cyclical versus structural question in emerging markets, we spoke to Causeway portfolio managers Arjun Jayaraman, Duff Kuhnert, and Joe Gubler.
Arjun, at what point will emerging markets become cheap enough to warrant a more aggressive allocation than you currently advocate for Causeway's international and global opportunities clients?