Fundamental headwinds due to the government shutdown along with technical weakness, a break of risin...
Negative sentiment is rising on emerging markets--here are my thoughts on why and what to do about it
08/02/2013 3:38 pm EST
You can see it in the performance numbers. For 2013 to date the IShares MSCI Emerging Markets ETF (EEM) was down 9.30% while the SPDR S&P 500 ETF was up 21.01%. Quite a trouncing for an emerging market index that was up 69.9% in 2009. From 2002 to its peak in 2007, the emerging markets index was up 320%
You can see it in the cash flows. In June $9 billion flowed out of ETFs that invest in international equities. The most unpopular ETF of all? The iShares MSCI Emerging Markets ETF, which saw outflows of around $4.4 billion.
And you can see it in the headlines. Here’s one from the Financial Times on July 27: “Book closes on the EM growth story.” Or how about this one from Bloomberg on July 22: “BRIC Bust Seen in Emerging Market Discontent With Growth.”
So what do you do? Do you go commando and contrarian and load up on an unloved asset because it is unloved? Do you follow the crowd and stay as far away as you can—until you see evidence that sentiment has turned? Do you wait as patiently as you can—with cash on the sidelines—until the current dislike turns to absolute hatred and then buy, hoping to catch a bottom in a historically volatile sector?
This isn’t exactly an academic question for me. The mutual fund I manage, the Jubak Global Equity Fund (JUBAX) had a little more than 20% of its stock holdings in emerging markets as of the end of May. The past performance of emerging markets matters to me—and figuring out the future direction of emerging markets is perhaps even more important.
I’ve been thinking a lot about the issue lately. And while I don’t have any definitive answers I do have something like a framework for looking for an answer.
I think the “problem” of emerging market performance—and the related issue of the negative sentiment on emerging markets—needs to be broken into three parts.
First, there is the objective data showing a slowdown in economic growth in such major emerging markets as China, Russia, India, and Brazil. (That pretty much covers the BRIC countries, right?) China, which used to do a reliable 9% or 10%, looks headed down to the official target of 7.5% or less. (You don’t have to search hard for an economist with a forecast of 7% or lower these days.) Brazil, to take another example, grew at a 7.5% rate in 2010 but at only 1.3% in 2012. The world’s developing economies will grow by 5% in 2013, the International Monetary Fund projected recently. That’s well below the 6.6% average annual growth of the last decade.
Second, I think there’s an objective/subjective problem that makes this slowing more disconcerting than a drop from 6.6% growth to 5% might be in other contexts. We’ve gotten used to thinking of the high GDP growth in developing economies such as China as the reason to invest there. China is growing at 9% so I’ve got to put money in Chinese stocks. (This shorthand way of thinking comes despite persistent evidence that there isn’t a solid connection between GDP growth rates and stock market performance. Just look at the performance of the S&P 500 recently during a period of economic growth in the United States that’s below trend for a recovery.) And we’ve gotten used to seeing a relatively small number of big cap stocks as proxies for the outperformance of developing markets. Vale (VALE), BHP Billiton (BHP), and Rio Tinto (RHP) are some New York listed big caps that represented an easy way to buy the emerging markets story. You can find other representatives of the most popular stocks for investing in the emerging markets story by looking at the top 10 holdings of the Vanguard FTSE Emerging Markets ETF (VWO): China Construction Bank, China Mobile, Industrial and Commercial Bank, Taiwan Semiconductor, American Movil, OAO Gazprom, CNOOC, Bank of China, and Tencent Holdings. When these stocks have faltered, it has felt as if the emerging markets sector is faltering.
Third, and this I think is mostly a subjective problem, what’s apparent in looking at the stocks that most investors use to invest in emerging markets—and we’re talking about some really, large stocks here with a market cap of $181 billion for China Construction Bank (CICHY) and $71 billion for Vale—is that they for the most part represent a specific model of economic growth, one that is based on commodities, and exports, and investment-led growth. I think what we’re seeing now in major developing economies isn’t just a slowdown but also a change from this export-led model for growth to one that is more domestically focused and more consumer focused. If that’s true that’s both an objective challenge to these economies—can they pull off this transition—and a subjective challenge to investors who are used to looking for their investment choices for these markets to a group of stocks that is no longer leading stock market and economic performance in these countries. The subjective challenge is to avoid generalizing—the underperformance of Vale isn’t an indication of underperformance for all of Brazil’s economy—and to become familiar with a new set of stock names that includes the leaders of a new pattern of growth that emphasizes the domestic consumer.
To go back to my original question, so what do you do now
I do think you need to recognize that the old export-driven, commodity names still haven’t found a bottom. As long as China or Brazil, for example, are groping toward a new growth foundation, commodity-based, export-oriented stocks can’t be said to have bottomed
I think you need to recognize that during this bottoming process we aren’t looking at a rising tide that lifts all boats. On the evidence of the last 12 months, it is possible to find domestic consumer stocks in emerging markets that do well but these stories are the exception rather than the rule. Yes, Kroton Educacional (KROT3.BZ) in Brazil is up 109.72% in the last 12 months or Tencent Holding (700.HK) in China is up 57.20% in the last 12 months or Industrias Bachoco (BACHOCOB.MM in Mexico or IBA in New York) in Mexico is up 73.04% but these stocks aren’t typical of the performance of domestic consumer stocks in emerging markets. (More typical is the 12.85% drop in shares of Natura Cosmeticos (NATU3.BZ) in Brazil or the 16.66% loss for Ping An Insurance (2318.HK in Hong Kong or PGAY in New York) in China.) Making money even in domestic consumer stocks in developing economies when sentiment is so against these markets is hard.
If my thesis about the shift in the economic models for these developing economies is correct, investors in these markets will have to learn a new set of stocks—and they’ll have to figure out how to trade them in local markets since relatively few developing economy domestic consumer stocks are listed in New York.
And, finally, investors will have to keep in mind that while domestic consumer stocks may outperform the old export driven stocks now and while they may outperform them in the long run, when sentiment about emerging markets does turn, the biggest quick winners are likely to be the old, familiar, beaten down exported driven stocks. You may not want to own them for the long haul but you surely will reap big returns if you can call the turn in sentiment.
At least that's how I’m thinking about investing in emerging markets for the next year or so.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of Industrias Bachoco as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/.
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