Choosing Developing Markets over Developed

It has become common to see the US equities reaching new highs. In fact, only US shares have peaked to all-time highs this year as a result of the tax cuts introduced by US President Donald Trump in 2017. Trump’s tax cuts pushed the earnings of the domestic companies higher. But the tax cut effects are now well soaked into the current prices and US stocks seems to be overvalued. While the secular bull market races off the charts, the precipitous drop in emerging market stocks since early this year have attracted investors, who hunt for long-term bargains amid the sell-off.

It has not been a successful year for the emerging market assets. The emerging market equities have significantly under performed the S&P 500 Index in 2018, with the S&P 500 up 6.5% and emerging markets down 4.4% through July.

Many investors would think to be away from the falling developing markets, especially amidst of trade war, strong dollar and rising fed funds rate. But this is only due to the negative sentiment of the retail investors as the fundamentals say a different positive picture. At this point, there will be a lot of institutional investors who would be entering.

The world markets fell before the trading session ended on Wednesday. Trump has taken the credit for all the stock market highs in last two years, but now when the US equities plunged, he called out Federal Reserve “crazy” and put the blame on the central bank for their hawkish outlook. Fed is expected to increase rate thrice in 2019.

Trump’s latest comments came as markets sold off sharply, with the Dow Jones Industrial Average dropping more than 800 points on Wednesday. The Nikkei index in Tokyo was down by 4.25% on Thursday afternoon, while in Hong Kong the index was down 3.9% and Shanghai was at its lowest mark for four years after a plunge of 4.15%. In Australia, the benchmark S&P/ASX200 index closed down 2.74%, suffering its worst one-day fall since February.

There are two major issues on the EM landscape today. First, there are countries stuck in synthesizing fiscal and economic policies, and second, there is China.

Turkey, South Africa, and Argentina are dealing with typical EM problems: weak policy decisions, wide deficits in the current account, excessive foreign-denominated debt and sliding currencies. Each of these countries have a difficult path to recovery ahead.

In the last two years, there had been large capital inflow to EM stocks and bonds. The threat of a rising dollar and rate hikes could create a panic in the developed economies which are holding large EM assets. The investor confidence is bound to get negatively affected even if the fundamentals outside these countries are relatively sound. Due to the smaller size of their economy, emerging markets won’t infect the rest of the world.

China is a different story. The GDP of China is expected to decline in the next quarter before the year ends. The trade war with the US may not affect the $12 trillion economy majorly, but China is still facing the domestic problems related to the slow demand by the middle class who contributed to the retail sector. In that case, if the trade war tantrums are extended then ultimately it will start disintegrating the second most powerful economy.

That said, China’s economy is multidimensional – and its strengths are often understated. China’s fundamental economic health is stronger than widely perceived, which gives policymakers room to maneuver when managing the current challenges.

The question is whether one should reduce the exposure to the emerging market assets or increase the allocation to the same. Without a doubt, investments in EM assets would be an important part of portfolio allocation. Investors with long-term horizons should maintain strategic exposures to EM stocks. The companies that are positioned to capture strong underlying economic growth offer attractive return potential when the current volatility settles.

Despite the routine political and economic conundrum, GDP growth is still likely to be much stronger across emerging markets than across developed markets in the years ahead. Many countries have strong current account balances with little foreign debt and are less vulnerable to a stronger dollar than in the past. US economic growth, which remains solid, has supported EM economic growth in the past, via demand for commodities and consumer goods. Earnings growth of EM companies has rebounded strongly since 2015, and EM valuations are deeply discounted versus developed-market stocks.