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Emerging markets for the short term

Emerging markets are a cyclical investment, not a long-term one. And the upcycle might be about to start.
June 18, 2020

Emerging markets might be a better short-term investment than long-term one, if history is any guide.

Even before the Covid-19 induced fall, MSCI’s emerging markets index was lower in US dollar terms than it was in 2007. If you’ve made money on them in recent years, then, it is either because of dividends (which are generally small), the failing pound, or good timing. They’ve not been a great long-term investment.

Which reminds us of something economists have been saying for years – that investors should not buy emerging markets because of their long-term growth prospects. There’s no correlation across countries over longer periods between equity returns and economic growth. One reason for this is simply that a share prices discount growth in advance.

There might, however, be a case for regarding emerging markets as a shorter-term play.

You might think this odd. Everybody says you cannot time the market.

This is true for the very short-term – say, for time horizons less than around six months. But it is not entirely the case for horizons of around 12 months because there have been useful lead indicators of returns on emerging markets.

My chart shows the point. It shows how just four lead indicators have predicted almost half the considerable variation in annual returns on emerging markets since 1997. Granted, these indicators have failed sometimes: they didn’t foresee the falls of 2001 or 2013 or the profits of 2006-07 for example. But they did correctly foresee the rises of 2003-04, 2009 and 2017 and the fall of 2011-12, 2015 and 2018. And while they didn’t foresee the full magnitude of the 2008 collapse they did correctly warn us that big trouble was coming.

Emerging markets, then, have been partly predictable. Right now, two of these lead indicators are warning us to stay out of the market, and two are signalling to buy.

One cautionary sign is the US yield curve. Thanks to a near-zero Fed funds rate, this is now upward-sloping in the sense that 10-year yields are above the funds rate. You might think this a good thing. Upward-sloping curves predict economic growth and hence increased appetite for risky assets.

Sadly, though, for emerging markets things aren’t so encouraging. Controlling for other things, there’s a negative relationship between the shape of the yield curve and subsequent annual returns. This suggests that, historically, emerging markets have tended to price in the signal sent by the yield curve.

Our second warning sign is simply that MSCI’s emerging markets index (in dollar terms) is below its 10-month average. Historically, this has warned us to stay out. This is because emerging markets, even more so than other stocks, are driven by sentiment. And sentiment is infectious: one investor’s bullishness spread to another. This generates momentum.

On the other hand, though, we have two bullish signals.

One is that emerging markets are cheap relative to developed markets, thanks largely to the strength of the US market. The ratio of MSCI’s emerging markets index to its developed markets index is now three-quarters of a standard deviation below its post-1997 average. In the past, this has led to emerging markets doing well.

Secondly, thanks to the fall in global share prices this year and to central banks’ printing money, the ratio of the money stock in developed economies to share prices is now above its normal levels. This tells us that western investors, on average, have unusually high levels of cash and unusually low levels of equities in their portfolios. When this has been the case in the past they have tried to rebalance their portfolios away from cash by buying equities, which has driven up share prices generally and emerging market equities too.

Now, you might think all this is typical economist fence-sitting: “on the one hand... but on the other...”

No. The point of regression analysis of the sort summarised by my chart is that it puts weights onto these different factors. And post-1997 evidence suggests that the bullish indicators are stronger, pointing to a rise in MSCI’s emerging markets index of around 30 per cent over the next 12 months.

Sadly, however, there’s a caveat here; yes, economists do sit on fences. The crisis might have caused historic relationships to break down. And the strong US dollar and lack of space for looser fiscal policy in many emerging markets threaten to cause a wave of corporate failures and weak recovery in many countries. Yes, in principle, such fears should be in the price and buying now should produce high returns if only as a reward for taking on high risk. But we can’t be wholly confident of this.

Only the bravest investor would therefore pile into emerging markets right now. It might instead be safer to wait until prices break above their 10-month (or 200-day) moving average. Doing this means we will not buy at the bottom and so will miss out on some gains. But it would be safer.

Emerging markets might not be a long-term investment. But they are a cyclical one. And cycles have uptrends as well as downtrends.