As I've said recently in my videos and in my posts on China, the tide of sentiment has turned against emerging markets and emerging market equities.
You can see it in the performance numbers. For 2013 to date, the iShares MSCI Emerging Markets ETF
(NYSEARCA:EEM) was down 9.30% while the SPDR S&P 500 ETF
(NYSEARCA:SPY) was up 21.01%. Quite a trouncing for an emerging market index that was up 69.9% in 2009. From 2002 to its peak in 2007, the emerging markets index was up 320%.
You can see it in the cash flows. In June, $9 billion flowed out of ETFs that invest in international equities. The most unpopular ETF of all? The iShares MSCI Emerging Markets ETF, which saw outflows of around $4.4 billion.
And you can see it in the headlines. Here's one from the Financial Times
on July 27: “Book closes on the EM growth story.” Or how about this one from Bloomberg
on July 22: “BRIC Bust Seen in Emerging Market Discontent With Growth.”?
So what do you do? Do you go contrarian and load up on an unloved asset because it is unloved? Do you follow the crowd and stay as far away as you can — until you see evidence that sentiment has turned? Do you wait as patiently as you can — with cash on the sidelines — until the current dislike turns to absolute hatred and then buy, hoping to catch a bottom in a historically volatile sector?
This isn't exactly an academic question for me. The mutual fund I manage, the Jubak Global Equity Fund
(MUTF:JUBAX), had a little more than 20% of its stock holdings in emerging markets as of the end of May. The past performance of emerging markets matters to me — and figuring out the future direction of emerging markets is perhaps even more important.
I've been thinking a lot about the issue lately. And while I don't have any definitive answers, I do have something like a framework for looking for an answer.
I think the problem of emerging market performance — and the related issue of the negative sentiment on emerging markets — needs to be broken into three parts.
First, there is the objective data showing a slowdown in economic growth in such major emerging markets as China, Russia, India, and Brazil. (That pretty much covers the BRIC countries, right?) China, which used to do a reliable 9% or 10%, looks headed down to the official target of 7.5% or less. (You don't have to search hard for an economist with a forecast of 7% or lower these days.) Brazil, to take another example, grew at a 7.5% rate in 2010, but at only 1.3% in 2012. The world's developing economies will grow by 5% in 2013, the International Monetary Fund projected recently. That's well below the 6.6% average annual growth of the last decade.
Second, I think there's an objective/subjective problem that makes this slowing more disconcerting than a drop from 6.6% growth to 5% might be in other contexts. We've gotten used to thinking of the high GDP growth in developing economies, such as China, as the reason to invest there. China is growing at 9% so I've got to put money in Chinese stocks. (This shorthand way of thinking comes, despite persistent evidence that there isn't a solid connection between GDP growth rates and stock market performance. Just look at the performance of the S&P 500
(INDEXSP:.INX) recently, during a period of economic growth in the United States that's below trend for a recovery.) And we've gotten used to seeing a relatively small number of big cap stocks as proxies for the outperformance of developing markets. Vale
(NYSE:VALE), BHP Billiton
(NYSE:BHP), and Rio Tinto
(NYSE:RIO) are some New York listed big caps that represented an easy way to buy the emerging markets story. You can find other representatives of the most popular stocks for investing in the emerging markets story, by looking at the top ten holdings of the Vanguard FTSE Emerging Markets ETF
(NYSEARCA:VWO): China Construction Bank
(HKG:0939), China Mobile
(NYSE:CHL), Industrial and Commercial Bank
(HKG:1398), Taiwan Semiconductor
(NYSE:TSM), America Movil
(NYSE:AMX), OAO Gazprom
(NYSE:CEO), Bank of China
(HKG:3988), and Tencent Holdings
(HKG:0700). When these stocks have faltered, it's felt as if the emerging markets sector is faltering. Third, and this, I think, is mostly a subjective problem, what's apparent in looking at the stocks that most investors use to invest in emerging markets—and we're talking about some really, large stocks here, with a market cap of $181 billion for China Construction Bank
(OTCMKTS:CICHY) and $71 billion for Vale — is that they, for the most part, represent a specific model of economic growth, one that is based on commodities, and exports, and investment-led growth. I think what we're seeing now in major developing economies isn't just a slowdown, but also a change from this export-led model for growth, to one that is more domestically focused and more consumer focused. If that's true, that's both an objective challenge to these economies — can they pull off this transition — and a subjective challenge to investors who are used to looking for their investment choices for these markets, to a group of stocks that is no longer leading stock market and economic performance in these countries. The subjective challenge is to avoid generalizing — the underperformance of Vale isn't an indication of underperformance for all of Brazil's economy — and to become familiar with a new set of stock names that includes the leaders of a new pattern of growth that emphasizes the domestic consumer.
To go back to my original question, so what do you do now?
I do think you need to recognize that the old export-driven, commodity names still haven't found a bottom. As long as China or Brazil, for example, are groping toward a new growth foundation, commodity-based, export-oriented stocks can't be said to have bottomed.
I think you need to recognize that, during this bottoming process, we aren't looking at a rising tide that lifts all boats. On the evidence of the last 12 months, it is possible to find domestic consumer stocks in emerging markets that do well, but these stories are the exception rather than the rule. Yes, Kroton Educacional
(BVMF:KROT3) in Brazil is up 109.72% in the last 12 months or Tencent Holdings in China is up 57.20% in the last 12 months or Industrias Bachoco
(NYSE:IBA) in Mexico is up 73.04%, but these stocks aren't typical of the performance of domestic consumer stocks in emerging markets. (More typical is the 12.85% drop in shares of Natura Cosmeticos
(BVMF:NATU3) in Brazil or the 16.66% loss for Ping An Insurance
(HKG:2318) in China.) Making money even in domestic consumer stocks in developing economies, when sentiment is so against these markets, is hard.
If my thesis about the shift in the economic models for these developing economies is correct, investors in these markets will have to learn a new set of stocks — and they'll have to figure out how to trade them in local markets, since relatively few developing economy domestic consumer stocks are listed in New York.
And finally, investors will have to keep in mind that while domestic consumer stocks may outperform the old export-driven stocks now, and while they may outperform them in the long run, when sentiment about emerging markets does turn, the biggest quick winners are likely to be the old, familiar, beaten-down exported-driven stocks. You may not want to own them for the long haul, but you surely will reap big returns if you can call the turn in sentiment.
At least that's how I'm thinking about investing in emerging markets for the next year or so.
Editor's Note: This article was written by Jim Jubak of MoneyShow.
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No positions in stocks mentioned.
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