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“Other people’s beliefs may be myths, but not mine.” – Mason Cooley
There is no doubt about it – for the past several years, emerging markets have been a poor trade and an even worse investment. Despite higher growth than developed economies, and better valuations, money has simply rewarded the proactive printing press as opposed to more longer-term potential. The media has been largely focused on the idea that emerging markets are in crisis mode, using the narrative of Federal Reserve tapering as the reason for why stocks in Brazil (EWZ), Russia (RSX), India (EPI), and China (FXI) are doomed to perpetual underperformance.Yet, as a mutual fund and separate account manager, the contrarian in me wonders just how justified such bearish sentiment is, and if in turn a massive opportunity the other way is coming. First, let’s do some myth busting. History shows that Quantitative Easing never resulted in a period where BRICs outperformed (went up more or down less) US stocks. Yet, the negative narrative on emerging markets is that as the Federal Reserve tapers its bond buying, emerging market stocks will end up suffering from less liquidity in the United States. This is an illogical argument. One cannot claim that an end to QE is bearish for emerging market stocks when QE never benefited them to begin with. Furthermore, the link between emerging markets is not between US and stimulus. Rather, the link is between the US and inflation expectations. If they rise as the Federal Reserve reduces stimulus (or rather if they continue to), then overseas assets could significantly outperform and play catch-up.
This brings us to the second myth to attack – the idea that a crisis is underway in BRICs. Yes – China has significant debt and may be risking a credit crisis. But risking a credit crisis in the future is different than pricing a crisis as if it has already happened.
To argue that debt alone is the reason not to buy emerging markets ignores the fact that US liabilities are likely considerably higher than China’s, once unfunded liabilities are factored in. Brazil’s problems are all well publicized. India has taken aggressive, proactive actions to reduce deficits and stem currency declines. Russia’s valuation multiples are in the low single digits. In 2013, emerging markets lagged US equities by the most since 1998 when a true emerging market crisis actually occurred. No such crisis has, for lack of a better term, emerged.When markets price in an event or scenario with 100% certainty as if it already occurred, a significant reversal can occur. How can we be confident that there is no crisis despite continued fear? Very simply, through the behavior of credit. Any real crisis in overseas markets will most certainly be reflected in debt instruments and yield movements. Those that remember the “taper tantrum” of May-June last year know full well how debt crisis behavior looks, as yields spiked and concerns of a meltdown were building.
The situation is entirely different now with the Federal Reserve actually tapering. Take a look below at the price ratio of the iShares JPM USD Emerging Market Debt ETF (EMB) relative to the US iShares 7-10 Year Treasury Bond ETF (IEF). As a reminder, a rising price ratio means the numerator/EMB is outperforming (up more/down less) the denominator/IEF.
Note the collapse in the ratio as US yields spiked, and the considerable resilience now. If there were a crisis and the breakdown in the equity side of the BRIC equation were valid, would not debt feel the impact of a breakdown even more?
That is not to say of course that emerging markets do not have problems. Of course they do. But at the end of the day, the business of trading and investing is not about whether things are good or bad, but about if prices have overreacted or underreacted. For emerging market stocks in 2013 to have behaved like they did on a relative basis to US markets as if a 1998 crisis took place is illogical. So too is assuming that the suppliers of developed markets will not participate in developed economic accelerated growth.
While momentum remains short-term negative, do not discard BRICs from your trading screens. After all – when BRICs move, they tend to do so sharply, violently, and in a way that usually is too late for most to take advantage of after the fact.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.