- Volatility is a given in emerging markets, but it’s also what creates amazing opportunities.
- Economics, fundamentals, and currencies are all in favor of emerging markets.
- China is just doing what the FED should have done 5 years ago: tighten after an expansion period.
Emerging markets are a volatile beast, this is a given. However, the inherent volatility is mostly the result of our perception and not of actual structural changes in a country. As an example, last year a wonderful buying opportunity emerged in Cemig (NYSE: CIG), a Brazilian utility from the state of Minas Gerais. CIG’s stock price fell from double digits to $1.05 in just a few years.
Figure 1: CIG’s stock performance. Source: Yahoo Finance.
What I did was pretty simple, but it also revealed volatility which isn’t something every investor has the stomach for. I first calculated CIG’s earnings in the worst-case scenario. However if things turned around, I would come to average earnings of around $0.3 for the foreseeable future. This also implied a dividend of $0.15 as the company is supposed to pay out 50% of earnings in dividends (currently 25%). I also asked a few students that I had from Belo Horizonte whether their lives had changed much in the last period, especially their electricity usage. Their reply was as I imagined, their lifestyles didn’t change much. Think about your lifestyle in a recession, most people just cut the holidays short or don’t buy a new car, but the basic life habits continue on unaffected.
Emerging markets have to be analyzed through such lenses. These aren’t the 1960s where crazy political policies in combination with bad weather killed 15 million people in China. Emerging market economies seem volatile, but the general growth trend remains stable. Market panics is what creates excellent buying opportunities, so excellent that it often looks too good to be true, like CIG was at $1.05.
For the record, I started buying CIG at around $1.7 back in 2015 when I expected a 30% return with low long term risk. As it’s impossible to catch the bottom in emerging markets, I watched CIG decline to $1.05, bought more, and then sold slowly from $2 to $3. As I said above, an issue with emerging markets is that you can’t know how low a stock can go. The best thing to do is to accept the volatility, know the fundamentals of a stock extremely well as in the long term those fundamentals will be reflected in the stock price, and be ready to buy more as the stock price and fundamentals diverge. As would Buffett say: A real investor is happy when stock prices fall because he can buy more for less.
Let’s take a look at the current situation and concerns surrounding emerging markets in order to determine whether there is an opportunity, or if the world as we know it is coming to an end (allow me a bit of sarcasm).
Emerging Markets Situation & Concerns
The situation with emerging markets is that they have underperformed in the last 5 years. As most managers are judged by using the S&P 500 as a benchmark, investors’ money simply left emerging markets and went where everybody goes, to the S&P 500. The S&P 500 returned 88% in the last 5 years while the MSCI Emerging Markets ETF (NYSEARCA: EEM) returned only 13%.
Figure 2: EEM vs the S&P 500 in the last five years. Source: Nasdaq.
(Warning 1: The EEM is a bad measure for emerging market performance as it’s a weighted index, but it’s fine to use it here as an indication of trends.)
From an economic perspective, Asian emerging markets have grown at an average of two to three percentage points faster than developed economies in the last five years. On top of that, the probability of a recession hitting emerging economies is minimal while it’s pretty high for the rest of the world.
Figure 3: The momentum in growth and development keeps the probability of a recession at minimum levels for emerging Asia. Source: IMF.
In the worst-case scenario, emerging Asia could slow down. This means that business growth would be just a bit slower. Therefore, the headline worries about a crisis in emerging Asia are totally overblown.
An eventual slowdown would be a problem if there were astronomic valuations, but that isn’t the case. The price earnings (P/E) ratio of the emerging markets ETF (EEM) is 14.30 which implies an earnings yield of 6.99%, while the P/E ratio of S&P 500 is at 25.41 which implies a 3.93% yield.
So, on the one hand we have a minimal probability for a recession and a return of almost 7%, while the herd is happy with a 4% yield and a 25% recession probability. As always, fundamentals will be what determines long term returns, so be careful where you put your money.
(Warning 2: An emerging market ETF is the wrong way to invest in emerging markets, a portfolio of 10 excellent stocks is much better. You can read more about my perspective on this topic here.)
As the FED started to hike rates, the U.S. dollar strengthened. This was especially true over the last 3 years. However given the above (figure 3) recession probabilities, there is a higher chance for the dollar to weaken in the long term than for it to strengthen further, especially in relation to fast growing emerging market currencies. Therefore, what has been a weight to international returns could soon become a tailwind.
Figure 4: The U.S. dollar has really strengthened in the last few years. Source: Bloomberg.
Main Worry: China Deleveraging
The main worry about emerging markets is the deleveraging going on in China with the central bank ‘draining’ the money supply. People often forget that the Chinese haven’t forgotten about the “no pain, no gain” principle in monetary policy. The current tightening will allow for more easing if the economy slows down. As long as the economy is growing at a healthy pace, there is no need for stimulus. Perhaps the FED should look up to the their Chinese counterparts.
Figure 5: China has allowed for interest rates to surge – 10-year government bond. Source: Trading Economics.
However, this isn’t slowing down economic growth, meaning that the Chinese are preventing the economy from overheating. This should be an excellent sign for investors because as soon as the economy slows down too much, stimulus will replace the tightening.
Figure 6: Chinese economic growth is picking up. Source: Trading Economics.
The mainstream media has turned completely toward increasing the number of clicks on a piece of news. Therefore, headlines and articles have to be shocking and filled with fear while sound economic analysis is getting scarcer. Constantly hearing how emerging markets are risky and about the trouble that is hitting China inevitably skews investors’ perception, especially as the S&P 500 just keeps going up. This makes stock prices diverge from the underlying fundamentals, with a premium for the S&P 500 and with a discount for emerging markets.
Emerging markets should make up a significant part of a well-balanced portfolio. Given that most investors are now overweight the S&P 500, it might be a good time to think about emerging markets as the fundamentals are better, economic growth is better, economic risks are lower, and there is a positive risk for currency benefits.
The majority of investors have forgotten that investing is about managing risk first, and not about betting on returns.