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 features Tyler Mordy, president and chief investment officer of Toronto-based Forstrong Global.
“Hot summer streets and the pavements are burning” begins the 1983 hit song, Cruel Summer, by British pop band Bananarama. Investors similarly fear a scorching summer in financial markets.
Sources of uncertainty are clearly numerous, ranging from the increasingly theatric U.S. elections to implications of “Brexit” to the timing of a Fed rate hike (although policy announcements are becoming a bit like Groundhog Day—with Federal Reserve Board Chair Janet Yellen popping her head out of the hole hoping to raise rates, only to back away each time).
Any measure of investor activity confirms current macro fears. Volume in inverse and volatility ETFs have reached new highs (recently accounting for more than 10% of the NYSE’s trading activity). Retail optimism toward bonds is also nearing a record high.
More Cash Holdings
Even the pros are nervous. The latest Bank of America Merrill Lynch Global Investor Survey shows fund managers currently holding 5.7% of their portfolios in cash, up from 5.5% in May and the highest level since November 2001. The new poll also showed risk appetite and global equity allocation at four-year lows.
Where to from here? At panic points like this, it is useful to revisit the role of the portfolio manager: Why do clients pay us to manage their wealth? It is not for flawless clairvoyance. Rather, we are paid to anticipate probable risks, prepare for opportunities and importantly, not lose our proverbial minds when everyone else has lost theirs.
That requires a disciplined approach that can extract emotion from the process.
To be sure, markets are reacting to some legitimate macro fears. Central bank actions are increasingly frantic, Brexit creates a long list of unknowns and global demand remains structurally deficient. And there are times when false beliefs can distort economic reality so much that they become reflected in asset prices (this is George Soros’ reflexivity thesis).
Bearish Bias Still Lingers
Still, since 2008, we have argued that postfinancial crisis periods are a different animal. Investors, still carrying crisis-made scar tissue, tend to cling close to shore. Endless financial crisis fears prevail—whether U.S. fiscal cliffs, Chinese devaluations, euro banking insolvencies, etc.
The narrative keeps shifting, but a bearish bias lingers. This time has not been different.
How should investors respond? Amid a renewed set of macro fears and heightened volatility, new market leadership may be surfacing. The 10%-plus year-to-date outperformance of emerging market equities against MSCI EAFE is particularly impressive. Perhaps more importantly, emerging markets have held up much better than their developed world counterparts in the Brexit-driven sell-off.
To most investors, this may seem unusual. After all, over the last five years, emerging markets have dramatically underperformed. And in a typical “risk off” period, one expects higher risk assets to fall more than others.
However, this is not the story in 2016, and it confirms our “overweight” positioning in domestic-focused, commodity-importing emerging market ETFs; namely, the iShares MSCI India ETF (INDA | B-97), the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-65), the iShares China Large-Cap ETF (FXI | B-44), the iShares MSCI Poland Capped ETF (EPOL | B-99) and the VanEck Vectors Vietnam ETF (VNM | C-31).
4 Emerging Market Drivers
Behind this relative stability lie four trends that bode well for emerging markets.
First, the U.S. dollar’s likely peaking is wonderful news (see “Here’s Why The US Dollar Is Peaking”). Emerging markets usually outperform during weak dollar periods.
Secondly, dovish monetary policy and lower commodity prices are driving long-term, domestic-interest rates lower.
Thirdly, the valuation gap between Asian and Western markets today stands close to 2003 levels (the last time a secular bull started).
Finally, fiscal easing—notably in China and India—bodes well for corporate earnings.
Foreign investors have not yet bought into the emerging market trend. However, historically emerging market rallies have been glorious ones—both in scale and duration.
Once a turnaround happens, the performance is likely to be anything but cruel.
Tyler Mordy, president and chief investment officer of Forstrong Global, is a recognized innovator in the design and application of global macro ETF managed portfolios. At the time of writing Mordy, along with Forstrong clients, held INDA, ASHR, FXI, EPOL, VNM. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.”