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.
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.
The average earnings yield for the U.S. since 1900 has been 7%, he says.
While rising valuations should have added 0.3% per year to returns, the actual return to U.S. equities has been +6.5%.
“This suggests 0.9%/year has been lost to slippage, which is not suggestive that the U.S. has been deserving of a premium P/E in the long run,” Inker explained.
6. What About in the Short Term?
Since 115 years is a pretty long time, some investors make the case for looking at how the U.S. has done more recently.
For the past 20 years, the U.S. has “clearly been nothing particularly special return-wise,” according to Inker.
“Over the past 10 and five years, it has been more impressive, in the top quartile of countries,” he explained.
7. Slippage in Other Countries
The “positive spin” on this chart could be that the U.S. has been giving a return higher than can be explained by its average earnings yield and valuation shift.
However, Inker adds, it “has not been ‘better than the rest of equities’ in that its slippage has been slightly worse than the median developed country over the period.
It’s also worth considering that emerging markets experienced worse slippage than the average developed market over this period, at an annualized rate of -0.4%.
Nonetheless, this “would have actually put it next in line to the U.S. over the period and …only 0.3 standard deviations away from the average over the period.”
8. Take the Middle Road
Analysis is better served by looking at more than 20 years of data, Inker asserts, and 40 years “would almost certainly be better.”
And here, a U.S. claim “to specialness over this period is more or less completely lacking,” he says. “Slippage was not materially different from the long-run result for the U.S., and the U.S. was precisely at the median of the countries we have data for.”
(He also points out that the U.K. had “the worst slippage of any country over the period, and was noticeably below median for the shorter period as well.”)
9. But What About Profits?
“The U.S. has been one of the highest ROE countries in the world over the last 40 years, as well as one of the most stable from a profitability perspective,” said Inker.
Since 1995, it was close to being the top country in the world as measured by ROE, coming in fourth out of 21 nations.
With a low standard deviation of ROE over the 20-year period, the U.S. had “the lovely combination of ‘high and stable’ return on capital, which is the hallmark of high quality companies,” the GMO executive says.
“This is certainly exceptional performance in a profitability sense, although because it hasn’t led to lower than normal ‘slippage,’ it implies that while the U.S. should trade at a higher price/book than the average country, it doesn’t deserve a higher P/E,” Inker explained.
Still, GMO “has consistently underweighted the U.S. versus non-U.S. markets for the last couple of decades, [and] what we at GMO seem to have gotten wrong is continually fading U.S. profitability back toward that of the rest of the world and its own longer history, while U.S. profitability has instead moved higher,” he admits.
10. The Final Word
The U.S. has “been pretty consistently more profitable and on a generally upward trend,” Inker says.
“We have been expecting some reversion to the mean on this measure, with the U.S. falling back toward its longer-term average, and the rest of the world closing some of the gap over time,” he explained.
However, the gap over the last decade “is smaller than it used to be, but the U.S. has shown no tendency to move back down.”
Why? “The clearest driver of the surprisingly good profitability is the rise in corporate profits as a percent of GDP.”
However, there’s still “a quandary for thinking about the U.S. stock market,” according to the GMO specialist: “We cannot find any convincing evidence that the U.S. is deserving of trading at a premium P/E to the rest of the world.”
Either the U.S. has “somehow unlocked a secret to permanently higher profitability or this is an extremely dangerous time to be investing in the U.S.,” he concludes.
To maintain high profitability with a low investment rate means further increases in wealth inequality, and generating sufficient end demand in such an economy “would call on either the rich to start spending their wealth at significantly greater rates than we have seen historically or the rest of households to spend more than 100% of their income, as they did in the housing bubble.”
Such scenarios can hardly be seen as foundations to a sustainable economy, Inker says. Plus, if the formula were sustainable, other countries would copy it.
“Despite the strong recent performance of the U.S. and the weak performance for emerging, neither has shown evidence that suggests we should change our assumptions,” the GMO executive stated.
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