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Time to sell emerging markets?

It’s time to dump emerging markets. That’s the message of the fact that MSCI’s emerging markets index (in US dollar terms) has fallen below its 10-month average. A rule to sell whenever this happens would have increased long-run risk-adjusted returns in the past because it would have saved us from big losses in 1995, 1997-98, 2000-01 and 2008-09.

In fact, there’s another reason to sell. US interest rates are likely to rise next year. Futures markets are pricing in a half-point rise with more to come in 2023. On some previous occasions (such as 1994-95, 2000 and 2018) even widely expected rises in US rates led to losses on emerging markets. This is because higher US rates reverse the 'reach for yield': why take the substantial risks of holding emerging markets when you can get good safe returns on US cash.

But, of course, things are not so simple. There are also reasons to stick with emerging markets.

Let’s be clear what these are not. It is emphatically not the case that we should hold emerging markets because countries such as India, Vietnam and China have great economic potential. Even if this is true, it is irrelevant because the link between longer-term economic growth and equity returns is weak. Figures from MSCI show that China has been by far the best-performing economy since 1998, but its stock market has lagged behind those of dull economies such as France or Denmark.

Instead, a better reason is that emerging markets are relatively cheap. The ratio of MSCI’s emerging markets index to its developed world index is now at an 18-year low. You might reply that this tells us more about how expensive US equities are than about how cheap others are, but the fact is that this ratio has in the past helped to predict annual returns on emerging markets.

Also, even if US interest rates do rise, they will stay very low by historic standards – low enough, perhaps, to support capital flows into emerging markets.

On top of this, of course, there are genuine uncertainties.

One, as you’d expect, is what happens to global equities generally. Emerging markets have a beta with respect to MSCI’s world index of just under one, based on annual changes since 1989, meaning that they tend to rise and fall roughly one-for-one as developed stock markets rise and fall. Yes, their relative cheapness might cushion them a little, but they are unlikely to do well if global equities fall.

A further uncertainty is the US dollar. If we control for changes in global equities, valuations and interest rates, a 10 per cent annual rise in the dollar against the Japanese yen has on average been associated with an 8 per cent fall in emerging markets since 1989. One reason for this is that a stronger dollar raises the cost of raw materials, which squeezes profits and real incomes. Worse still, companies and governments with dollar-denominated debts see their debt servicing costs rise as the dollar rises. If rising US interest rates – or merely the anticipation thereof – raise the dollar, therefore, emerging markets would suffer.

A third uncertainty is US bond yields. Rising yields are strongly associated with rises in emerging markets: the two coincided in 2000, 2005-06, 2016-17 and this year (if we take 10-year yields). This correlation holds even if we control for changes in global equities, the US dollar and the fed funds rate. There’s a simple reason for it. Emerging markets are risky assets – even more so than other equities – and so they rise when investors’ appetite for risk increases. And when it does so, investors dump safe assets such as US Treasuries, causing their yields to rise.

The impact of a rising fed funds rate upon emerging markets thus depends crucially upon what happens to bond yields. If the Fed raises rates at a time when yields are rising because of increased optimism for the world economy, emerging markets will do well. But if on the other hand investors fear that higher short rates will weaken the economy and so bond yields fall, emerging markets will suffer badly.

You might think all this is horribly inconclusive. But that’s as it should be. Assets should not be so egregiously mispriced that their next move is obvious. And if you think it is obvious, it’s very likely that you are missing something important.

But there is something we can say. What we have here is an old but underappreciated issue in investing – the debate between rules and judgment.

Although judging whether we should hold onto emerging markets is tricky, one good rule gives us a clear steer: the 10-month rule tells us to sell. Now, this rule does not always work, and it has sent wrong buy and wrong sell signals in the past. But it does have one great virtue: it protects us from the long and deep bear markets that really destroy our wealth. If your main objective is to avoid heavy losses you should stick with this rule even if doing so comes at the risk of missing out on gains. There is – as indeed there should be – a trade-off between capital preservation and profit.