One is that the MSCI emerging markets index (in US dollar terms) is above its 10-month average as I write. History tells us that a simple policy of buying when this is the case, and selling when prices are below their 10-month average, has significantly beaten a buy-and-hold strategy, in large part because it means we've avoided some nasty bear markets.
Another signal is that emerging markets are cheap relative to the US. The ratio of MSCI's emerging markets index to the S&P 500 is one-third below its post-1987 average. This matters, because history suggests that the ratio is mean-reverting: a high ratio predicts a fall, and a low ratio a rise. Since January 1996, there's been a statistically significant correlation (of minus 0.32) between this ratio and its subsequent annual change.
Third, the US yield curve (measured by the gap between 10-year Treasury yields and the fed funds rate) is upward sloping. This has predicted decent returns on emerging markets in the past, because an upward-sloping yield curve predicts decent economic growth and hence usually a rising appetite for risk.
All these bullish indicators pose the obvious question: what could possibly go wrong?
One hugely important factor here is the US bond market. Falls in 10-year yields are usually associated with falls in emerging market equities. In fact, emerging markets are more tightly linked to US bonds than to US equities. The correlation is stronger - at 0.52 versus 0.47 for annual changes since January 1996. And so is the sensitivity; since 1996 a one standard deviation annual rise in bond yields has been associated on average with a 12.3 per cent annual rise in emerging markets whereas a one standard deviation rise in the S&P 500 has been accompanied by only a 9.3 per cent rise in emerging markets.
This link is especially tight in bear markets. Five of the six worst falls in emerging markets in the last 20 years have been accompanied by falls in bond yields.
There's a simple reason for this. Emerging markets are risky, even relative to other shares. Volatility since the 1990s implies that there's three times as great a chance of an annual fall of 20 per cent or more in emerging markets than there is in the S&P 500. And since 1987 (when MSCI data began) the five worst months for emerging markets have seen an average monthly fall of 21.3 per cent, whereas the S&P's five worst months have seen average losses of just 12.5 per cent.
Annual change in emerging markets and US bond yields
An investment in emerging markets is therefore a bet on investors' appetite for risk increasing. If this happens, however, bond yields would probably rise as investors sell safer assets to buy riskier ones.
Conversely, falls in appetite for risk usually mean big drops in emerging markets - as these are especially risky assets - but falls in bond yields as investors seek out safer assets.
Because risk appetite usually increases when the world economy is growing, and falls when growth falters, bond yields and emerging markets are usually cyclical.
You might imagine that with the US economy expected to do well this year - perhaps in part because of hopes that President Trump will increase infrastructure spending - risk appetite should increase, to the benefit of emerging markets and the detriment of bonds. This is consistent with what lead indicators of emerging markets are telling us.
Yes, this is probably the most likely scenario. But falls in appetite for risk usually come as surprises, or as the result of surprises. These, of course, cannot be ruled out nor predicted.
Luckily, however, there's an obvious solution for any investor worried by this possibility. The good correlation between bond yields and emerging markets suggests that bond funds are an obvious hedge against a big drop in emerging markets, as these would do well if risk appetite falls.
They're not a perfect hedge, though. For example, both bonds and emerging markets might sell off if investors' demand for liquid assets rises, which could happen if they fear a tightening of monetary policy: in the 'taper trantrum' of 2013, bonds and emerging markets both did badly, for example. Alternatively, emerging markets might sell off at the same time as bonds do badly if growth in emerging economies such as China disappoints the markets while growth in the US exceeds expectations. Risks such as these, however, can be mitigated by holding cash.
Many of the worst risks to emerging markets can therefore be diversified away. Emerging markets might be risky in themselves, but these risks can to some extent be laid off.
