The investment adage “buy when there is blood on the street” sounds good in theory but is tough to do in practice. Even hardened contrarians struggle to buy assets that are in freefall and appear to have lost their parachute.
Emerging markets are a good example. They are badly out of favour as investors fear a sharper slowdown in China, further commodity-price falls, and a capital exodus out of developing markets if the United States raises interest rates faster than expected.
The MSCI Emerging Markets Index, which covers stocks across 23 countries, fell 16.9 per cent over 12 months to October 31 (in US dollar terms). The annualised loss over five years is 2.5 per cent. By comparison, the S&P 500 is flat over 12 months and up 12 per cent annually over five years.
That’s a massive difference in equities performance between US and emerging markets since 2010. Thankfully, this column has been bullish on international investing in the past few years, partly because of a view that the Australian dollar, when trading above parity with the Greenback had to fall. The preference was to own US equities and avoid emerging markets.
But every asset has its price. The MSCI Emerging Market Index is trading on a forward Price Earnings (PE) multiple of 11 times and a price-to-book value of 1.43 times, MSCI data shows. The MSCI World index, which covers 23 developed countries, trades on a forward PE of about 16 times and price-to-book ratio of 2.19 times.
It gets worse at a regional level. The MSCI Emerging Markets Latin America index has lost 36 per cent over one year to October 31, 2015. The MSCI South East Asia index is down 23 per cent and the MSCI Emerging Markets European index is off 25 per cent.
MSCI data for dozens of emerging-market indices is a sea of red across one, three and five years. Only a handful of emerging markets have eked out positive gains in this period and returns over 10 years have been mostly negative or in low single digits.
Positives are hard to find for emerging markets in 2016. Manufacturing activity in China, a key consumer of emerging-market goods, is slowing. Commodity prices, in my view, have further to fall as demand weakens and supply takes longer to adjust. That is bad news for large resource-based countries such as Indonesia and Malaysia.
Moreover, the risk of a flight of capital – possibly another 1997-style Asian Financial Crisis – as money flows back to the US as interest rates rise cannot be ruled out. There could be a stampede of investors out of Asia if higher US interest rates suck capital from the region.
Waning confidence about the strength of emerging-market currencies is another headwind. As is the potential for economic crises to spark political crises and further volatility.
Clearly, it is far too soon to say the worst is over for emerging markets. Prospective investors who take advantage of depressed prices in the region must be able to withstand high volatility, hold for at least three to five years and recognise that emerging markets should only ever be a small portion of a balanced portfolio. As a guide, international share funds typically hold about 5 per cent of their portfolio in emerging-market equities.
Caveats aside, history shows the best time to buy emerging markets is often during real or perceived crises when panic selling creates opportunities.
According to Research Affiliates, a prominent global researcher on asset-allocation strategies, emerging markets are trading on a Shiller PE of 11 – an all-time low. The Shiller PE compares the current PE to historical values and allows the PE to be viewed through multiple business cycles rather than be biased by latest events.
For comparison, US equities are trading on a Schiller PE of 25 times. Australia’s is on 14 times. Simply put, emerging-market equities are trading well below their median (19 times) and US equities are trading well above the median (16 times).
Research Affiliates also predicts emerging-market equities will have a higher real expected return over 10 years than developed-market equities, albeit with greater volatility. It forecasts a 10-year annualised return for emerging markets of 7.9 per cent. US equities will deliver a 1.1 per cent annual return over 10 years, after strong gains over the past five years.
As an aside, Research Affiliates’ predicted 7.4 per cent annualised real return for Australian equities over 10 years is the second-highest in the developed world, after Spain at 8 per cent.
The case to lift emerging-market allocations cautiously within portfolios is strengthening. Long-term investors have no need to rush: emerging markets face a rocky 2016 as US rates rise. But it is time to put them back on the portfolio watch list.
Taking a diversified approach through exchange-traded funds make sense. The iShares MSCI Emerging Markets ETF trades on ASX and is bought and sold like a share. It aims to replicate the price and yield of the MSCI Emerging Markets index.
The index is unhedged for currency movements. It has lost 2.82 per cent in Australian dollar terms over one year to November 30, 2015. Investors who believe emerging-market equities are getting closer to the bottom, and that developed-market equities look expensive, should investigate the iShares MSCI Emerging Markets ETF or similar ETFs offered by Vanguard.
Nobody says it is easy buying assets when there is so much negativity in commentary and when uncertainty is rife. But the worst-performing assets over a decade have habit of outperforming the following decade. That will be true of emerging markets in time.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at December 5, 2015