Mark Dow: 3 Things Emerging Markets Need For A Rebound

September 08, 2015

Mark Dow is the founder of Dow Global Advisors, based in Laguna Beach, California. He is also the author of the Behavioral Macro blog. Dow has 20 years of experience as a policymaker, investor and trader, focused on global macro and emerging markets. He has been a senior portfolio manager at Pharo Management LLC, a portfolio manager at MFS Investment Management and a senior sovereign analyst at Putnam Investments. Dow began his career in Washington as an economist at the International Monetary Fund and at the U.S. Department of the Treasury. We've seen a big sell-off in emerging markets, with iShares MSCI Emerging Markets (EEM | B-100) falling to a multiyear low.
Mark Dow: Last time we got this low was 2009. It has broken out of that channel it's been in for the past four or five years. What prices do you look for before you would start seeing value in emerging markets? Or is it just too hot to handle?
Dow: I'm not very value-oriented in a certain sense. I started writing in 2011 that I was getting bearish emerging markets and it was going to last a while. It's really the mirror image of what we had seen from 2003 until about 2010. And that just had to unwind. Once that starts unwinding, it feeds on itself, and the asset allocators start needing to get out. You go through the cycle.

Toward the end of that cycle, you see an accelerated phase of risk shedding. And then at some point, you see some combination of three things showing up that will get institutional investors to allocate to the asset class again. For emerging markets, you need these three things to line up pretty nicely.

The first one is U.S. interest rates. You need to have some kind of educated guess as to when rate hikes will stop. We're still at the point where we're kind of guessing when the rate hikes will start. You need to be in a position to feel like you have an educated guess as to where they're going to stop. We're just not there. This is important because the opportunity costs of capital for the people allocated to emerging markets are U.S. rates.

So if rates are going up, it makes it harder to allocate to emerging markets. Emerging markets historically tend to do well when rates are coming down. That's typically the case. It wasn't entirely the case in the last cycle, but it usually is.

Second is the dollar. People are still calling for the dollar to rise powerfully. That may or may not happen. But as long as that's the expectation, investors are going to be wary of allocating to emerging markets because in both local currency fixed income and equities, a significant part of the return is determined by currency, much more than people recognize.

The third factor you have to look for is a projected growth differential. In emerging markets, they don't have property rights. The rule of law is not as strong. So you need to be compensated for those additional risks. And typically that compensation comes in the form of a growth differential—not valuation differential, but usually growth differential. In terms of growth versus the U.S.?
Dow: Yes, versus the developed economies from which the allocations would be coming.

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