Executive Summary

Emerging equities are more volatile than developed market equities. This owes little to the volatility of emerging stock markets in local terms and much more to the strong positive correlation between their local stock markets and movements in their currencies. The spring of 2018 was a classic example of this, with US dollar strength driving significant emerging weakness. Emerging markets do exhibit momentum, so it would not be odd for the weakness to persist for another quarter, although after transaction costs the momentum effect is probably not capturable. Our analysis of the underlying fundamentals for emerging markets, on the other hand, gives us confidence that the assumptions behind our forecasts are sound and emerging value stocks represent the most attractive asset we can find by a large margin, and in the longer term we believe valuation is much more predictive of returns for emerging than momentum is. Our models do not take into account the potential effects of a trade war, but while a trade war is presumably a negative for emerging assets, it should arguably be at least as negative for US assets and seems unlikely to change much about the relative attractiveness of emerging markets in global portfolios.

Emerging markets had a really lousy second quarter. This was true for pretty much any index with “emerging” in the name, regardless of whatever other words were there along with it. MSCI Emerging Equities (EM) was down 8%. The JP Morgan EMBI Global Diversified Bond Index (EMBI) hard currency bond index was down 3.5%. The JP Morgan GBI-EM Global Diversified+ local debt index (GBI-EM) was down 10.4%, and the JP Morgan ELMI Plus emerging currency index (ELMI) was down 5.8%. With the S&P 500 up 3.4% for the quarter and MSCI EAFE down a tame 1.2%, it was therefore a pretty tough quarter for our asset allocation portfolios given our large bias toward emerging securities and against US equities.1 Whenever we have a quarter like this we react by looking at what happened, why it happened, and whether it poses a challenge to the assumptions that caused us to have the biases in our portfolios in the first place. In this case our analysis suggests that what has happened is not particularly out of line with other historical events in emerging markets. The event shows starkly the distinction between emerging and developed markets and is a demonstration of why we consider emerging markets to be riskier than other assets that we invest in. Momentum has historically mattered in emerging markets, so there is some reason to expect that there may be more pain to come in the short term. However, nothing that has happened in the markets or to the underlying fundamentals causes us to doubt our longer-term thesis that emerging markets are the best investment opportunity available today by a substantial margin.

So what happened last quarter, and why were emerging markets hit so hard? Simply put, it was a very strong quarter for the US dollar (USD), with the DXY dollar index up 5%.2 That is a 1.1 standard deviation event, which makes it a little out of the ordinary, but not a true outlier. It probably comes as no surprise that when the USD rises, the US stock market outperforms non-US markets. But what makes emerging markets unique is the fact that this doesn’t simply occur due to the currency translation effect. This quarter, for example, the currency basket of MSCI Emerging fell by 4.8%, precisely the same as the fall for the currency basket of MSCI EAFE. In other words, while some specific emerging currencies fell a lot in the quarter – the Turkish lira fell 13.4% and the Brazilian real fell 10%, for example – you’d be hard-pressed to call this a general case of emerging currency weakness so much as USD strength. But while MSCI EAFE rose 3.5% in local currency terms, slightly outpacing the rise in the S&P 500, MSCI Emerging fell 3.5% in local currency terms. This is par for the course. It is only a mild overstatement to say that the basic difference between the developed world and the emerging world is that when a developed world country has a declining currency, all else equal that is good for that country’s stock market, whereas when an emerging country has a declining currency, all else equal that is bad for that country’s stock market.