Emerging markets have dramatically underperformed the S&P 500 since the launch of the first EM ETF in 1987. However, during that period, there have been stretches of outperformance. In fact, there appears to be a cycle. EM outperformed from 1987 to 1994, underperformed from 1994 to 2000, outperformed from 2000 to 2010, and underperformed from 2010 until the present. I believe we may be nearing the end of the current down cycle, and approaching a period of EM outperformance. I also believe EM is relatively inexpensive compared to the S&P 500, and that yields on both EM equities and EM debt make a good case for EM investing here. And, finally, I believe that there are significant tail risks ahead for the US and Europe, and some diversification is warranted.
Analyzing the Cycle
If indeed there's a cycle in the relative performance of EM vs. US, how much longer will the current downswing last before the next upswing?
The lengths of the last three EM/US cycles were 2192 days, 2464 days, and 3682 days. That's an exponential progression. If the progression continues, the current cycle should be around 4550 days. We're currently at 4110 days. So, we may be nearing the end of the cycle. (But this is by no means an exact science; I just think it's interesting).
Analyzing Valuation
Let's compare some basic price ratios on an EM ETF and an S&P 500 ETF. This data comes from Fidelity.
IEMG
P/E: 12.15
P/B: 1.76
P/S: 1.42
P/FCF: 8.63
Dividend Yield: 3.08%
SPY
P/E: 23.00
P/B: 4.30
P/S: 3.00
P/FCF: 17.22
Dividend Yield: 1.27%
So you're paying roughly 2x as much for the S&P 500 as you are for emerging markets. That might make sense if you expect EM economic growth to greatly lag US economic growth, but that isn't really the story that the economic data tell. The US's share of global GDP has stayed approximately the same over the last several decades (~15%), while EM's share of global GDP has increased from approximately 42% in 1996 to about 60% currently. 71% of global GDP growth is in emerging markets, and only 29% is in developed markets. So the data don't support the view that the US economy is growing much faster than EM.
Rather, I think US equities have a high premium for a couple reasons. First, US companies have done a really good job of increasing earnings a lot faster than the economy grows. S&P 500 profit margins have steadily grown from about 6% in 1994 to about 14% today. Secondly, interest rates in the US have gradually fallen over the last several decades, and as interest rates fall, stock market multiples expand. (Instead of buying bonds, investors buy stocks when bond rates and yields are low.) However, we may be nearing the end of both of these trends. 0% is probably the floor for nominal interest rates in the US, and corporate profit margins can't expand forever. (I don't know where the ceiling for margins might be, but I suspect that rising margins are related to falling interest rates, so that if rates hit a floor, margins will hit a ceiling.)
If multiple and margin expansion in the US start to hit a limit, then the future of multiple expansion and margin expansion will be emerging markets, where rates are still way above zero and can go a lot lower. Plus, EM investors will get paid a much higher dividend yield in the meantime.
EM Debt vs. EM Equities
Traditionally, US investors have been advised to maintain a 60-40 portfolio-- 60% stocks, 40% bonds. But with real yields on US bonds deeply negative, a lot of US investors have gone to an all-equities allocation. I'd argue that one way to get bond exposure with better yield is to buy EM bonds rather than US bonds.
Comparing VWOB vs GOVT is informative. VWOB is an ETF of sovereign EM bonds, and GOVT is an ETF of sovereign US bonds. As you can see, the overall yield-adjusted return on VWOB has been significantly higher since the start of our data in 2013. The distribution yield on VWOB is about 4.52%, and the distribution yield on GOVT is about 1.43%. So you get way more yield on VWOB. The default risk is higher too, of course, which is why VWOB is more volatile than GOVT.
Note that there's been a big dip in relative valuation recently. There are a couple reasons for that. First, with inflation high, emerging markets have been raising interest rates and tightening financial conditions a lot faster than developed markets. And second, the Russian invasion of Ukraine raises the risk that both Ukraine and Russia will default on sovereign debt.
I don't know where the relative bottom will be, but I've been buying EM debt on the way down. We're heading into a monetary tightening cycle that poses risks to all global asset prices, but since emerging markets are so far ahead of developed markets in the cycle, it's possible that a lot of the tightening is already priced in for EM.
Tail Risks
One of the reasons that EM equities and bonds are less popular than the US equivalents is that they're seen as being exposed to a lot of tail risk. The Russian invasion of Ukraine is a good example. Autocracy and political instability can lead to bad leadership decisions that tank markets.
But I think the US has more political tail risk exposure than we'd like to admit. Our political discourse has been deteriorating for years, with partisanship extremely high, membership in civic organizations extremely low, and voters' policy views increasingly unhinged. Victims of our own success, we're being targeted by highly effective propaganda machines in Russia and China that seek to sow the seeds of political instability. We've also got so much money sloshing around in this country that our political process is being targeted by corporate lobbyists and criminal syndicates as well. It's not a good sign when companies get 10x the return from investing in lobbyists than from investing in R&D. The US still ranks low on measures of corruption, but that's largely because the scales aren't built to estimate the kind of corruption we have in the United States (e.g. "access money").
Consider that the leading presidential candidate for 2024 is under investigation in multiple jurisdictions for financial fraud and is widely suspected of connections to the Russian government, yet there's no real sign of his party even trying to muster a primary challenger. And on the other side, you've got a guy with unprecedented low approval ratings, and his party doesn't seem to be trying to muster a primary challenger either. I don't know how you break the two-party duopoly, but it's increasingly dysfunctional. And all this political dysfunction is arguably parasitic on economic growth.
Perhaps even more worrying than political tail risk is climate tail risk. Granted, the US has more resources than other countries that it can deploy to adapt to a changing climate. But it has one big vulnerability that EMs don't have: the North Atlantic current, which is reportedly on the verge of collapse. When the North Atlantic current goes, there will be catastrophic changes in climate for both North America and Europe. The southern hemisphere is less exposed. So, I think southern hemisphere investments make for good diversification to protect against specifically northern hemisphere climate risks.
Analyzing the Cycle
If indeed there's a cycle in the relative performance of EM vs. US, how much longer will the current downswing last before the next upswing?
The lengths of the last three EM/US cycles were 2192 days, 2464 days, and 3682 days. That's an exponential progression. If the progression continues, the current cycle should be around 4550 days. We're currently at 4110 days. So, we may be nearing the end of the cycle. (But this is by no means an exact science; I just think it's interesting).
Analyzing Valuation
Let's compare some basic price ratios on an EM ETF and an S&P 500 ETF. This data comes from Fidelity.
IEMG
P/E: 12.15
P/B: 1.76
P/S: 1.42
P/FCF: 8.63
Dividend Yield: 3.08%
SPY
P/E: 23.00
P/B: 4.30
P/S: 3.00
P/FCF: 17.22
Dividend Yield: 1.27%
So you're paying roughly 2x as much for the S&P 500 as you are for emerging markets. That might make sense if you expect EM economic growth to greatly lag US economic growth, but that isn't really the story that the economic data tell. The US's share of global GDP has stayed approximately the same over the last several decades (~15%), while EM's share of global GDP has increased from approximately 42% in 1996 to about 60% currently. 71% of global GDP growth is in emerging markets, and only 29% is in developed markets. So the data don't support the view that the US economy is growing much faster than EM.
Rather, I think US equities have a high premium for a couple reasons. First, US companies have done a really good job of increasing earnings a lot faster than the economy grows. S&P 500 profit margins have steadily grown from about 6% in 1994 to about 14% today. Secondly, interest rates in the US have gradually fallen over the last several decades, and as interest rates fall, stock market multiples expand. (Instead of buying bonds, investors buy stocks when bond rates and yields are low.) However, we may be nearing the end of both of these trends. 0% is probably the floor for nominal interest rates in the US, and corporate profit margins can't expand forever. (I don't know where the ceiling for margins might be, but I suspect that rising margins are related to falling interest rates, so that if rates hit a floor, margins will hit a ceiling.)
If multiple and margin expansion in the US start to hit a limit, then the future of multiple expansion and margin expansion will be emerging markets, where rates are still way above zero and can go a lot lower. Plus, EM investors will get paid a much higher dividend yield in the meantime.
EM Debt vs. EM Equities
Traditionally, US investors have been advised to maintain a 60-40 portfolio-- 60% stocks, 40% bonds. But with real yields on US bonds deeply negative, a lot of US investors have gone to an all-equities allocation. I'd argue that one way to get bond exposure with better yield is to buy EM bonds rather than US bonds.
Comparing VWOB vs GOVT is informative. VWOB is an ETF of sovereign EM bonds, and GOVT is an ETF of sovereign US bonds. As you can see, the overall yield-adjusted return on VWOB has been significantly higher since the start of our data in 2013. The distribution yield on VWOB is about 4.52%, and the distribution yield on GOVT is about 1.43%. So you get way more yield on VWOB. The default risk is higher too, of course, which is why VWOB is more volatile than GOVT.
Note that there's been a big dip in relative valuation recently. There are a couple reasons for that. First, with inflation high, emerging markets have been raising interest rates and tightening financial conditions a lot faster than developed markets. And second, the Russian invasion of Ukraine raises the risk that both Ukraine and Russia will default on sovereign debt.
I don't know where the relative bottom will be, but I've been buying EM debt on the way down. We're heading into a monetary tightening cycle that poses risks to all global asset prices, but since emerging markets are so far ahead of developed markets in the cycle, it's possible that a lot of the tightening is already priced in for EM.
Tail Risks
One of the reasons that EM equities and bonds are less popular than the US equivalents is that they're seen as being exposed to a lot of tail risk. The Russian invasion of Ukraine is a good example. Autocracy and political instability can lead to bad leadership decisions that tank markets.
But I think the US has more political tail risk exposure than we'd like to admit. Our political discourse has been deteriorating for years, with partisanship extremely high, membership in civic organizations extremely low, and voters' policy views increasingly unhinged. Victims of our own success, we're being targeted by highly effective propaganda machines in Russia and China that seek to sow the seeds of political instability. We've also got so much money sloshing around in this country that our political process is being targeted by corporate lobbyists and criminal syndicates as well. It's not a good sign when companies get 10x the return from investing in lobbyists than from investing in R&D. The US still ranks low on measures of corruption, but that's largely because the scales aren't built to estimate the kind of corruption we have in the United States (e.g. "access money").
Consider that the leading presidential candidate for 2024 is under investigation in multiple jurisdictions for financial fraud and is widely suspected of connections to the Russian government, yet there's no real sign of his party even trying to muster a primary challenger. And on the other side, you've got a guy with unprecedented low approval ratings, and his party doesn't seem to be trying to muster a primary challenger either. I don't know how you break the two-party duopoly, but it's increasingly dysfunctional. And all this political dysfunction is arguably parasitic on economic growth.
Perhaps even more worrying than political tail risk is climate tail risk. Granted, the US has more resources than other countries that it can deploy to adapt to a changing climate. But it has one big vulnerability that EMs don't have: the North Atlantic current, which is reportedly on the verge of collapse. When the North Atlantic current goes, there will be catastrophic changes in climate for both North America and Europe. The southern hemisphere is less exposed. So, I think southern hemisphere investments make for good diversification to protect against specifically northern hemisphere climate risks.
Comment:
The last chart in that update should have been this one. Note, again, that this is the non-dividend-adjusted chart:
China is easing its monetary policy while most of the world is tightening, so it's possible that China will outperform. It's basing here, and major constituents of the China index—like Alibaba—look really attractive at current cash flow yields:
Latin America growth has historically been lackluster, but expect it to benefit from high oil prices. Free cash flow yields in Latin America are really high right now, and the Latin America ETF has some momentum:
My next VWOB buy levels (note that this is the non-dividend-adjusted chart) are 68.64 and 60.67:
I'm also watching EM high-yield (HYEM), with buy levels at 20.15 and 16.84: