In the 12 months ending Sept. 30, the MSCI Emerging Equity index has dropped 19.3% — much more than the 0.6% decline in the S&P 500.
“It would seem to qualify as a nightmare year” for emerging markets, says Ben Inker, head of GMO’s Asset Allocation team, in the firm’s latest quarterly newsletter – but not quite.
For the 12 months ending Sept. 30, 1998, the MSCI Emerging plummeted 48%. Looking back over the data, Inker adds, it is “abundantly clear that things have been quite bad for half a decade now — as the group has been “losing by 12.2% per year” vs. the rest of the world for five years.
Put another way, a dollar invested in this index was worth about $0.83 over that period vs. a dollar invested in MSCI EAFE — the Europe, Australasia and the Far East index — which grew to $1.21 and a dollar in the S&P 500 to $1.87, the asset specialist points out.
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But does this mean investors need to turn their attention (and funds) to the U.S. markets instead? It’s complicated, Inker argues.
Read on to see how the GMO Asset Allocation chief breaks down an answer to this important question.
(Check out Jeremy Grantham’s contribution to GMO’s quarterly newsletter in Grantham: 12 Economic Facts to Ruin Investors’ 2016.)
1. Varying Performance Figures
The short answer to the EM vs U.S. debate, Inker explains, entails looking at whether or not the emerging markets may have “ ‘deserved’ some of their bad luck over the last several years.” His team does “not believe that emerging is a value trap,” he states in the recent investor letter.
(Note that emerging markets were behind in many time periods, but beat the S&P 500 in the 15-year timeframe.)
Furthermore, while the GMO team can’t say “that emerging doesn’t have its share of problems or that the U.S. may not pull a rabbit out of its hat, … we do not currently see any reason to assume the worst from emerging or the best for the U.S.”
The average earnings yield for emerging market equities over the past 20 years has been 6.7%, according to Inker.
While we might expect real returns to be 6.7% over the period, the earnings yield of emerging actually has risen from 4.8% to 7.6% since 1995. (“A rising earnings yield equates to a falling price, and the effect of that change has been to suppress returns by 3% per year,” he explained.
A fair return in emerging equities, then, should have been 3.7%, but the actual return has been 3.3%.
The 0.4% difference, or gap, is what analysts like Inker refer to as “slippage,” which translates to the conclusion that emerging market stocks have indeed “done a bit worse than one would expect given their earnings yield,” Inker says.
However, global estimates for worldwide slippage, he adds, are around 0.5% per year — which means emerging equities “have been almost exactly in line with what we expected from them.”
Still, Inker points out, there is a fly in the ointment: These returns are local real returns, “so there remains the possibility that currencies could have led to further problems for emerging equities.”
3. What About Currencies?
Inker notes that falling currencies have (of course) been “a significant driver” of losses in emerging equities over the past few years.
And while, the local return of emerging stocks was -7.1% while the loss from the currency movements cost 13.1%, in the 12 months ending Sept. 30, investors shouldn’t conclude that they need to hedge currencies in the EM holdings.
“In fact, it seems to be a spectacularly bad idea,” Inker said, “as we can see in Exhibit 3. This is a truly striking chart.”
That’s because, since 1995, the real returns of +3.0% in U.S. dollars for emerging equities turn into a “truly depressing” +0.9% return when hedged.
Even if investors had known currencies were going to decline, hedging only would have cut the “currency pain” by slightly more than half, Inker explains, “as the high interest rates in emerging countries would have eaten into the gains of being short the currencies.”
In addition, he concludes that emerging currencies are a “risk asset” of sorts and “have delivered a return above U.S. cash over time and should probably continue to do so given the capital needs and vulnerabilities of emerging economies.”
Furthermore, real returns to emerging equities “have been reasonably close to the average earnings yield if you adjust for starting and ending valuations, and that’s about all you can ask from equities.”
4. What About the U.S.?
While Inker’s analysis in the first part of his GMO letter suggests “that valuing emerging equities in the fashion we are doing seems justified,” investors may be wondering whether or not there is more upside and/or value in U.S. equities.
“Has the U.S. actually outperformed other markets in the long run? The short answer is yes,” he explained.
The U.S. comes in third out of 21 countries, and the return “was a full 2% per year better than the average of all 21,” Inker adds.
The data could prompt a conclusion that investors should “stay away from Europe,” but much of the weak performance can be tied to the two world wars, he points out.
Running a regression using invasion or civil war as one factor and massive inflation as another, the expected return to any country experiencing neither over the period “moves to +5.7%, leaving the U.S. 0.8% per year better than expected, down from the 2% outperformance versus all countries,” the analyst states.
His conclusion? In the long run, we “could say the U.S. shows evidence of being better than average, but probably not being ‘exceptional.’ ”
5. Has the U.S. Experienced ‘Slippage’?
Since 1900, the U.S. has “certainly not acted ‘better than equities’ in the sense of having a return higher than could be explained by its earnings yield and valuation shift,” Inker argues.