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By David Stevenson –
In this column I want to tempt fate and suggest that now might be the time to think again about tiptoeing back into emerging markets.
Now, long-term readers of this column in ETF Strategy will immediately start shaking their head and remind me that I’ve been a fairly optimistic type for some emerging markets for at least the last six months – over which time I’d note emerging markets stocks have started a quiet but steady rebound!
In particular, I’ve made myself about as popular as a socialist at a Tea Party rally by championing (with some big reservations) Chinese equities. I entirely understand why the hard money brigade might be of the view that the World’s Next Great Superpower is about to implode into a Minsky-inspired credit deflation bust…but I simply don’t agree. Frankly, this argument strikes me as one of those “horse bolting stable” arguments. Yes, China does have a growing and potentially dangerous addiction to credit but it’s not like it’s unique in that regard.
Collectively, the global system is addicted to credit, for all sorts of bad and good reasons. Hard money types for instance are pushing their money back into dollar assets, seemingly oblivious to the fact that much of the US recovery is being powered by……yes, you guessed it, consumers borrowing more! Yes China has rotten corporate governance and is very probably being propped up by a giant State complex that wants to make the macros look good, but I could say the same thing about Japan….and more! And why has no-one noticed that many large Chinese stocks are now initiating progressive dividend policies?
Anyway, my broader point is that the contrarian in me finds lots to disagree with my friends within the emerging market mavens community and especially about China. But my enthusiasm for emerging and especially frontier markets has always been tempered by two completely unassailable facts.
The first is that the global emerging markets ‘bloc’ as captured by the likes of the benchmark MSCI Emerging Markets Index contains within it absolutely massive variation between countries, styles and sectors. To say that all emerging markets are unloved and unwanted is to me the height of developed world arrogance. To give one small example, Cross Border Capital, a London-based independent investment advisory firm, focuses on global liquidity flows as a measure for risk on/risk off trades. Last week in its one of its superb reports, it suggested that although emerging market capital flows looked terrible, frontier market flows looked to be holding very strongly. This variety between emerging markets and frontier markets is also reflected at the national level where some markets have had a truly awful time, whilst others have had a less than awful time over the last 12 months. More importantly as the current global bull market continues its run, we would reasonably expect a growing dispersion of returns within all asset classes moving forward – emerging markets included.
Where might these dispersions start to emerge? The two tables below hint at where I believe we might see some big investment themes emerge. The first table looks at a range of US ETFs boasting above-average dividend yields. This list of funds reminds us that the income, dividend-focused opportunity within emerging markets is a very real and growing opportunity.
Emerging Markets ETFs in US market:
|Symbol||Name||Annual Dividend Yield %||P/E Ratio||Beta|
|RBL||SPDR S&P Russia ETF||4.43%||14.18||1.98|
|GUR||SPDR S&P Emerging Europe ETF||4.02%||9.73||2.19|
|EEMS||iShares MSCI Emerging Markets Small-Cap ETF||3.96%||n/a||2.1|
|DEM||Emerging Markets Equity Income Fund||3.89%||9.42||2.13|
|DVYE||iShares Emerging Markets Dividend ETF||3.81%||n/a||2.18|
|DBEM||MSCI Emerging Markets Equity Fund||3.72%||n/a||2.22|
|PLND||Market Vectors Poland ETF||3.60%||13.46||3.12|
|FRN||Frontier Markets ETF||3.59%||11.36||1.94|
|AFK||Market Vectors-Africa Index ETF||3.54%||9.86||1.44|
|EEME||MSCI Emerging Markets EMEA Index Fund||3.33%||8.29||3.11|
|VWO||Emerging Markets ETF||3.30%||11.76||2.35|
|DGS||Emerging Market SmallCap Fund||3.24%||10.35||2.16|
|GULF||Middle East Dividend ETF||3.10%||10.91||-1.82|
|EMFT||SPDR MSCI EM 50 ETF||3.06%||n/a||-4.28|
|EPOL||iShares MSCI Poland Capped ETF||3.01%||13.8||3.19|
|EVAL||MSCI Emerging Markets Value Index Fund||2.95%||n/a||3.52|
|BIK||SPDR S&P BRIC 40||2.92%||9.02||1.97|
|EZA||iShares MSCI South Africa ETF||2.72%||13.09||2.72|
|ERUS||iShares MSCI Russia Capped ETF||2.62%||4.73||2.04|
|PXH||FTSE RAFI Emerging Markets Portfolio||2.60%||n/a||2.21|
|FEM||Emerging Markets AlphaDEX Fund||2.58%||10.2||2.32|
|RSX||Market Vectors Russia ETF||2.54%||10.43||2.04|
My second table uses data from the quant team led by Andrew Lapthorne at French bank Societe Generale. It looks at the dividend yields and earnings growth rates for different national markets. What’s remarkable is that many emerging markets countries have now turned into dividend-income favourites yet some of that may be explained by simple contrarian, earnings-driven logic.
Russia, for instance, yields at an aggregate level around 4.3% but Societe Generale analysts (along with the mainstream) expect earnings per share to tumble by 34% next year. But I’d yet again note that China is stuck at a 4.2% yield with earnings per share (EPS) growth rates at 10.2% this year and 8.6% next year – not stellar but hardly a complete travesty in terms of growth! Again I’m also impressed by numbers from Hong Kong, South Korea and even Brazil (!). For me, it is not indisputably true that every high yielding, low valuation market is clearly a crackpot market where earnings are vanishing down a permafrost plug hole. Variations between national markets, within national markets based on different sectors and between global sectors based around style tilts will make a huge difference in the next 12 months.
Country Market Dividend Yields (Source: Societe Generale)
|Country||Dividend Yield 2013 estimate||2013 EPS Growth Rate||2014 EPS Growth Rate|
My second point is that all asset classes and markets, even widely reviled ones, go through cycles and that eventually they come out the other side looking like tomorrow’s winners. I was reminded of this iron law by a recent paper from Richard Titherington who is CIO at JP Morgan Asset Management.
A few weeks back Richard called time on the current emerging markets malaise, with four main observations:
- Against a backdrop of bleak headlines, emerging market equities have quietly outperformed over the summer.
- This is a young asset class, so cyclicality and volatility are normal. History shows that when investors are at their most pessimistic on emerging markets, a strong buying opportunity is created.
- Waiting for earnings and growth to rebound has often meant missing out on a significant part of the market recovery.
- With valuations still signalling extreme pessimism, this looks like a good time to buy.
Richard goes on to detail exactly why he believes that emerging markets are now flashing a strong buy, courtesy of a timing signal that “looks at three factors: valuations, trailing earnings and earnings expectations. A buy signal is generated as profits become depressed relative to history, earnings expectations are low and valuations become cheap.” The current signal is shown in the chart below.
According to the JPMorgan Asset Management guru, now is the time to make a move on emerging markets: “Historically, a valuation above 2.5x price/book value (P/B) has been a sell signal and a valuation below 1.5x P/B has been a buy signal. Where are we now? ROE has fallen and earnings continue to disappoint, pessimism is entrenched and valuations remain below 1.5 P/B despite the recent rally. Can valuations go lower? Can currencies fall below fair value? Yes, they can, but a cyclical asset class with high volatility is a buy in these circumstances for investors with a one-to three-year horizon and only a sell for those with a three- to six-month time horizon”.
This seems to me to be a very strong argument. Might emerging market stocks fall lower? Possibly? Are emerging market stocks only really for the adventurous who is willing to use volatility to their advantage? Indisputably, yes!
Given these two facts, where would I be looking to build exposure using ETFs?
I’d be looking at focusing on four main themes:
- Income enhancement by focusing on certain countries with decent yields – Lyxor‘s recent addition of a range of new national EM trackers will be useful here. My own preference is for Taiwan, Hong Kong, Malaysia and Thailand as individual countries, although I also have a soft spot for Turkey as well!
- ETFs with a value style tilt for emerging markets could do well, especially those such as the PowerShares FTSE RAFI Emerging Markets Portfolio ETF (PXH) or its London-listed equivalent, the PowerShares FTSE RAFI Emerging Markets ETF (PSRM).
- Sector-wide themes within the emerging market space built around say utilities or consumer stocks. The focus here would be on MSCI EM global sector indices and accompanying trackers with a defensive tilt (DeAWM and Lyxor have ETFs in this space)
- High beta emerging market sectors powering ahead i.e, banks (especially Chinese) or energy stocks? These high beta sectors and their accompanying ETFs might increase substantially in price if vigour returns to the emerging markets space.