Emerging Markets Submerge of Late

In celebration of the Fourth of July, I wrote about how we are fortunate to have the freedom that other countries don’t always enjoy. Specifically, I wrote about China and its recent crackdown on Alibaba after the founder and CEO Jack Ma made comments that the government found unacceptable (you can read the article by clicking here).

Little did I know that we were at the beginning of a terrible month for emerging markets stocks. While the S&P 500 and MSCI EAFE index of developed market stocks both enjoyed gains, the MSCI Emerging Markets index of stocks fell -6.73 percent, the worst showing since the bear market at the outset of the pandemic.

The rough month didn’t do anything to upset the since inception out-performance of emerging markets stocks, but it’s been a while since they’ve fared better than US stocks.

In theory, investors should be compensated for the political risk that comes with investing in emerging markets, but we’ve gone ten years now where that hasn’t been the case (and not by a little), which makes it a little bit of a tough pill to swallow.

Over the weekend, the Economist had an interesting article talking about how emerging markets have struggled, despite optimism following the 2008 financial crisis. The theory then was that the US economy wasn’t going to grow much in the wake of the crisis and that emerging markets would.

The Economist notes that in the 1980s, only 34 percent of emerging market economies were growing faster than our economy. By the 2000s, however, 82 percent were growing faster. As a result, poverty fell, and a new global middle class was emerging that could power emerging market stocks higher.

That’s not exactly what happened. Instead, commodities busted after the 2008 financial crisis, which disproportionally hit emerging markets countries.

More importantly, the US was able to spend itself out of the 2008 financial crisis thanks to the Federal Reserve. And when the coronavirus came along, the same thing happened again both here and abroad.

Except for this time, we also produced a vaccine that’s allowing us to get back to work more quickly than others. While nearly half of the US population is fully vaccinated, the Economist reports that only five percent of people in the developed world outside of China are vaccinated.

Although the article doesn’t reference it, our companies have simply been more successful. Yes, Alibaba has been an amazing company and stock, but Amazon has been more so. And that’s just one example.

So why continue to own emerging markets stocks? For a few reasons.

First, they comprise 15 percent of the global stock market, and we don’t think it makes sense to ignore such a large proportion of the total market. We’re underweight emerging markets, but we don’t plan on zeroing them out.

Second, after 10 years of underperformance, they’re a lot cheaper than US stocks. The price-earnings ratio of emerging market stocks is 16.4, versus 26.5 in the US, suggesting a 40 percent discount.

Other measures point in the same direction: the price-to-book, price-to-sales, and price-to-cash-flow ratios all show that emerging markets stocks trade at a 38 to 53 percent discount to the S&P 500.

In other words, investors are aware of the risks of investing in emerging markets and are pricing the risks in. It’s likely that there will always be a discount to compensate for the political risk, but the discount isn’t always this large.

Of course, we don’t know if or when the discounts will shrink, but it makes sense that overvalued markets are likely to cool off while undervalued markets are likely to pick up.

Hopefully, emerging markets will stage a turnaround in the near future. Several prognosticators have suggested that they would for years now, and we’re still waiting.

But, as the old saying goes, if you aren’t bothered by the performance of something in your portfolio, then you’re not well-diversified. We intend to stay well-diversified.