What’s Next for the Emerging Markets?

by Daniel Putnam | March 14, 2013 1:39 pm

The bull market may be roaring here in the United States, but investors in emerging-market stocks have been left out in the cold. But the disparity doesn’t necessarily mean it’s time to jump into those lagging stocks. Indeed, the great days of these once-hot stocks may be drawing to a close.

iShares MSCI Emerging Markets Index Fund (NYSE:EEM[1]) has lost 2.2% year-to-date, light-years away from the 9.5% gain for the S&P 500, as tracked by SPDR S&P 500 (NYSE:SPY[2]). Investors are certainly taking note: EEM has experienced $1.2 billion in redemptions so far in March, the largest outflow in the ETF universe. Vanguard FTSE Emerging Markets (NYSE:VWO[3]), iShares FTSE China 25 (NYSE:FXI[4]) and iShares MSCI Brazil (NYSE:EWZ[5]) have suffered the fifth-, sixth-, and ninth-worst outflows, respectively, to the collective tune of $1.3 billion.

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There are lots of causes for this underperformance, but the common theme is the same: The emerging markets just aren’t meeting investors’ expectations for outsized economic growth. China’s slowdown has received the most attention following the recent efforts of the country’s central bank to drain liquidity from the financial system, but Brazil is having plenty of problems of its own as it struggles with low growth and elevated inflation, and India is expected to register its slowest growth in more than 10 years. Further, price weakness for industrial commodities is dampening performance the resources-heavy markets of Brazil and Russia.

Dollar Strength Taking a Toll

While those factors have played a big part in the emerging markets’ underperformance, another issue has been even more important — the rally in the U.S. dollar. The PowerShares DB U.S. Dollar Index Bullish Fund (NYSE:UUP[7]), the largest ETF designed to track the performance of the greenback, is up 4.1% since Jan. 31 — since then the EEM has fallen 1.9% and trailed the S&P 500 by nearly 6 percentage points.

On a longer-term basis, the two funds have an extreme negative correlation. Keeping in mind that correlation runs on a scale from -1.0 to 1.0, with -1.0 being a perfectly negative correlation and 1.0 being perfectly positive, EEM’s five-year correlation with UUP is –0.84. In other words, the emerging markets haven’t stood a chance with the dollar performing as well as it has.

A Warning Sign for U.S. Equities

This isn’t the first time we’ve seen the emerging markets decouple from U.S. stocks in the recent past. The same divergence actually occurred at this same time last year, and it proved to be a warning sign for U.S. stocks.

In March-April 2012, EEM returned -4.8% and sharply lagged the 2.1% gain of SPY. In May, U.S. equities were hit for a loss of 6%. Similar divergences occurred in August 2008, March 2010, and the second quarter of 2011. It isn’t a perfect indicator, but it’s worked enough times in recent years that it bears watching now as the S&P 500 closes in on an all-time high.

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What’s Next?

While the dollar’s rally is on the upper end of the range relative to other upturns that have occurred in the past three years — meaning that it could well be due for a pause at this point — there’s no reason to begin bottom-fishing in the emerging markets just yet. Given that this type of underperformance has preceded larger selloffs for the emerging markets on numerous occasions, a more prudent course is to wait for a correction to get in at a better price and capitalize on a rebound.

Longer term, it may be time to ask whether the emerging-market story has largely run its course. EEM remains well ahead of SPY since its inception on April 7, 2003, with an average annual return of 16.1% versus 8.0% for the S&P 500 ETF. But these big numbers obscure the fact that all of the outperformance was generated in the first half of the time period. Since the market low of March 9, 2009, EEM has logged a cumulative return of 124.7% – not bad, but still well below the 149.2% total return of SPY. Investors may therefore question whether emerging-markets stocks — which are nearly 50% more volatile than U.S. equities* — are truly paying them for the added risk.

*Based on 3-year standard deviations of EEM and SPY, as reported on the issuers’ websites.

Source URL: https://investorplace.com/2013/03/whats-next-for-the-emerging-markets/

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