In this week’s economic/market commentary, Contango Capital Advisors’ Investment Strategy Group examines why emerging market economies continue to grow faster than developed economies while, over the same period, their stock markets have been languishing.
The most widely used emerging market stock index is the MSCI EM Index. For the 12 months ended in September 2011, this index returned ‐16% in dollar terms. Over that same period, the S&P 500 returned +4%. The spread between the two – almost 20% – is not insignificant for investors, many of whom have 10%‐20% in EM stocks in their globally allocated portfolios.
Yet gross domestic product (GDP) looks likely to grow only about 1.5% this year while the economies of the BRIC emerging countries (Brazil, Russia India and China) will grow collectively somewhere in the 7% range. This is a large difference and one that is likely to continue.
Ups and Downs
Why are emerging market stocks going down if the economies are doing so well? This apparent paradox underscores several important tenets of investing. First, investors don’t invest in economies; they invest in stocks, bonds and other securities. Second, markets – especially stock markets – are forward looking. And third, valuation matters.
In 2010, as we began to scale back emerging market exposure in our portfolios, some clients, understandably, asked us why. We offered several reasons:
–Many emerging economies were overheating, posing the risk of burgeoning inflation. The natural reaction by EM central banks would be an attempt to cool down the economy through tighter monetary policy. This, we suspected, could hurt stocks.
–Fund flows had gotten overly one-sided. From June 2010 through December 2010, total fund assets in EM stock mutual funds rose from $143 billion to $202 billion. That’s a 40% gain in just six months and indicative of an unsustainable move. By September of this year, assets were back down to $171 billion.
–We began to develop some particular worries related to China. Specifically, a property bubble seemed to be emerging that had/has the potential to damage the nation’s banking system. And China has been a credit-fueled success story if there ever was one, so if a tightening of credit were to occur, it would not be likely to have a positive impact. Additionally, we began to detect a pattern of increasing IPOs directed at US investors as well as growing corporate fraud at Chinese-listed companies. It had a dot‐com feel to it.
–Finally, with Ben Bernanke in charge of the Federal Reserve, we bet that monetary policy would stay easy here at home, encouraging a weaker dollar and better trade terms for large US corporations that sell globally to developed as well as emerging market countries. In many ways, the record earnings that US corporations posted earlier this year reflected the Fed’s implicit weak‐dollar policies and helped to bolster US stock prices.
A number of metrics that we use to indicate valuation for emerging market stocks as a whole have become more attractive. For example, the dividend yield of emerging market stocks is now as attractive as it’s been since 2008, and above its long-term average.
Similarly “cheap” readings are found when we look at EM price to earnings ratios, price to book value ratios, and company cash flow relative to market price. And, given our still generally bright outlook for these economies as a whole, we are more inclined to add back EM exposures to our portfolios once we see the dark clouds currently looming over the global economy and China begin to give way to clearer skies.
This article was prepared by Contango Capital Advisor’s Investment Strategy Group. Contango Capital Advisors is an affiliate of Zions Direct.
IMPORTANT NOTE: Wealth management services are offered through Contango Capital Advisors, Inc. (Contango), a registered investment adviser and a nonbank subsidiary of Zions Bancorporation. Investments are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value of the amount invested. Some representatives of Contango are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a nonbank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company (WNTC), a subsidiary of Zions Bank and an affiliate of Contango. CCA1011-0177