This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.
When evaluating emerging markets, we believe it is important to consider them not as a whole, but rather more granularly at the country and regional levels. The point is that while emerging markets share similar traits and characteristics, they all offer investors different flavors of risk and reward.
Over a market cycle, countries and regions behave differently; with that in mind, ETFs can help investors target the right emerging market exposure at the right time.
The fact that commodities appear to be in a secular bear market leans toward a market weight or underweight of emerging markets.
However, once one begins to analyze the underlying countries, it becomes easier to identify economies that are poised for growth. It’s important to recognize that emerging markets play a part in a diversified portfolio, but the addition of too much emerging markets exposes the portfolio to geopolitical risks often far above and beyond those of developed nations.
The quick takeaway is that Asia seems to be worth the risks, especially in China, with funds like the SPDR S&P China ETF (GXC | C-33). But first a bit more on what’s attractive and what’s not in the emerging markets, and why.
Global Themes Affecting Emerging Markets Today
We believe that while emerging markets are cheap on a broad valuation basis, an intelligent breakdown is needed to weed out the losers from the potential winners. For instance, investors who want to capture major growth opportunities in Asian countries such as China, India, Indonesia, Taiwan and Korea could benefit by avoiding other areas that are likely to be less prospective.
Those less attractive options include countries in Latin America and elsewhere that struggle with the financing of their current accounts and that could be hit by currency crises at any time—think Brazil, Turkey, South Africa and Russia.
In addition to zooming into the individual country level to pick the best opportunities within emerging markets, hedging currency exposure can also reduce volatility inherent in international investing.
Commodities On Defense
We also believe commodities are in a new secular bear market.
Thus, the commodity-based countries are struggling, and the strong dollar is hurting those with current account-financing issues. Energy-sensitive countries such as Brazil, Russia, Colombia and Mexico have been hit hard by the commodity weakness. The weakness has affected the countries’ currencies and their local economies.
Meanwhile, countries that are net energy importers, such as China and India, have benefited from lower-priced oil.
More broadly, the S&P 500 Index, as of April 30, had a forward price-to-earnings multiple (P/E) of 17.7, while the MSCI EAFE Index had a forward P/E of 16.48 and the MSCI Emerging Markets Index had one of 13.09. Investing in emerging markets is comparatively cheap, and the underlying growth rate is high.
One other observation worth noting is that frontier markets have a forward P/E of 10.78, according to data compiled by Bloomberg. That’s cheap, and frontier markets offer genuine diversification and lower correlation than emerging markets. They are a genuine diversifier but, of course, have their own extreme political risks.
Political Risks Not Compensated
Political risk and currency risk are extreme, and lately investors have not been compensated for the higher emerging market volatility.
Here are a few examples of material political risk that occurred just in the first quarter of 2015:
Officials at state-owned Petrobras have been accused of corruption in their dealings with construction companies. The government has ambitious plans to improve the nation's fiscal and monetary framework, but a rapidly declining approval rating is hampering the administration's ability to implement effective measures.
Market sentiment suffered as a result of public hectoring of the central bank by the political leadership, along with other political tensions. A plan to replace the parliamentary system with a presidential system is creating rifts with the ruling party. Due to the deteriorating macroeconomic outlook, the government suggested it could miss its 4 percent growth target in 2015.
The struggle continues with Greece and its creditors to recraft a bailout package. It has yet to produce a revised economic plan that satisfies its creditors.