Over the past few years, emerging markets have trailed the S&P 500 badly. So much so, that many high-net-worth investors are starting to take notice.
This chart illustrates the point nicely. It compares the relative value of the MSCI emerging market index (MSEMF) to the value of the U.S.-based S&P 500 index (SPX). A value of 1.0 on the right hand side means the value of the indexes are equal.
As you can see, over the past several years, there's been a considerable performance differential between the two. The MSCI emerging market index is currently valued at just over 50 per cent of the value of the S&P 500. In the past, when the relative value approached this level (in 2006 and in 2009, both times), the next move was strongly to be to the upside for emerging markets.
What's behind the current underperformance? Well, unlike previous emerging markets crises – such as the Russian currency crisis of 1998 – it's not one event, but rather a confluence of politics and economics.
First (and perhaps most importantly), there's a classic "risk off" trade. As the U.S. Federal Reserve ends its quantitative easing program, U.S. bonds have started to look more attractive. At the same time, the economies of the euro zone and Japan have shown signs of picking up. As a result, money has exited emerging markets, and gone into developed markets.
The second issue is China, which has experienced a surprise decline in manufacturing lately. Questions also remain about the country's "shadow banking" system. Because many emerging markets hinge on Chinese growth, investors are worried about a "ripple effect."
Third, there have been heightened political and economic risks in certain influential markets. For example, the Argentine peso plunged 15 per cent on Jan. 23, the currency's sharpest drop since the country defaulted on its debt a decade ago. Turkey, Thailand, and Ukraine are other examples. All three countries are facing political unrest, and in Ukraine, the country is very near to reaching a tipping point. Obviously, the more political turmoil, the more economic turmoil too.
The resulting selloff may create some interesting opportunities in emerging market equities, fixed income and currencies. There's a compelling case that emerging market stocks may soon represent better value than North American stocks. The market value of Google, for example, is now higher than the entire Brazilian stock market index. Wells Fargo is now worth more than India. And Starbucks is worth more than Turkey.
Of course, such quick "sound bite" comparisons aren't a substitute for in-depth market analysis. But they do give you an easy-to-understand idea of the potential disconnect between market perception and reality. For contrarians like me that spells opportunity over the next 3– to 5-years.
Some of my high-net worth clients have expressed an interest in boosting their emerging market allocation, and I've had conversations with several more (both in Canada and the U.S.) who are keeping a close eye on things. If you're interested in following their lead, here are a few things to keep in mind:
When will the bottom come for emerging markets? Tough to say (nearly impossible, in fact). Most of the pros I've spoken to think the problems currently affecting many emerging markets aren't the kind that get solved overnight, which means that opportunities to average in over time may soon be at hand.
Not all emerging markets are created equal
When I first started in the business almost 30 years ago, it was possible to speak about emerging markets as a single asset category. Today, there's a much greater appreciation for the individual dynamics that drive given markets. That's not to say that a broad-market ETF or index fund doesn't have its place (particularly for budget-conscious investors with moderate-sized portfolios). But for those willing to do the research, it may make more sense to investigate individual countries.
To hedge or not to hedge?
Part of the problem with investing in emerging markets is dealing with currencies: impressive gains on the underlying investment can be quickly eroded by currency weakness when translated back to CAD or USD. That said, you can make a good deal of money being on the right side of currency movements.
Ultimately, the question of hedging is an individual one. But if you're interested, you've got options. Many providers offer low-cost versions of emerging market ETFs that hedge back to CAD. More sophisticated investors can set up these hedges themselves.
Think outside the equity box
When you think about emerging market opportunities, it often pays to think about more than just equities. Long/short multi-strategy portfolios, fixed-income, and currencies are all worth taking a look at. The same goes for active management: emerging markets are one area where there's a lot of market inefficiency, and that's exactly the environment where teaming up with knowledgeable managers can make a lot of sense.
For investors with some courage and a three– to five-year outlook, there is considerable upside in emerging markets. Using a multi-strategy approach and allocating to equities/fixed income/currency holdings is the preferred strategy at this juncture.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. (www.stennerinvestmentpartners.com) The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.