3rd Quarter 2018

There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith

The US stock market continued to grind upward during the third quarter, despite concerns about interest rate sand trade wars. The S&P 500 returned 10.6% year-to-date compared to negative returns for the MSCI EAFE and Emerging Markets indexes. Growth stocks outperformed, with the Russell 1000 Growth Index up 17.1% year-to-date compared to the modest 3.9% return for the corresponding Russell 1000 Value Index. MLPs strengthened, returning 5.9%, driven by strong cash flow growth and Energy Transfer Partners’ (ETP) announced merger with its General Partner, Energy Transfer Energy (ETE). This merger eliminates the associated incentive distribution rights and simplifies the corporate structure. The MSCI EAFE Index, which tracks developed markets outside the US, suffered small losses, returning -1.4%. Emerging markets suffered significant declines, with the MSCI index returning -7.7%. Small cap and growth companies in emerging markets fared worse. The MSCI Emerging Market Small Cap Index returned -12.3%, and the MSCI Emerging Market Growth Index returned – 10.3%. The best place to be in Emerging Markets was Russian and Brazilian energy stocks, with the Energy sector within the EM index returning 17.1% year-to-date.

Emerging markets were the best performing major segment of the global equity markets during the 2000s, with the MSCI Emerging Markets Index returning 16.2% annualized compared to 1.4% for the S&P 500 for the ten-year period ending December 2010. Since then, these numbers have nearly reversed. From January 2011 through September 2018, emerging markets returned 1.3% and the S&P 500 returned 13.8% annualized. The outperformance during the 2000s resulted primarily from a market recognition of better economic policies in these countries and a corresponding decrease in poverty rates. During the 2000s, for example, Brazil’s poverty rate declined by 50%, driven by 7% annualized income growth for the bottom ten percent of the population. A boom in commodity prices supported these reforms and policies, but commodity importers such as India and China also participated in the boom.

After the 2008 Financial Crisis, emerging markets performed in line with the S&P 500 until around mid-2012. Underperformance picked up when China’s economy slowed in 2014, with weak demand contributing to declines in commodity prices that triggered severe recessions in Brazil and other commodity exporting countries. The emerging economies began to recover in 2016 and staged an impressive rebound in 2017. The underperformance this year stems from three primary factors – the stronger dollar negatively impacting countries with dollar-denominated debt, headline risk of trade wars and a slowdown in China driven by President Xi Jinping’s deleveraging campaign.

While emerging markets took 2017’s Fed tightening in stride, this year it began to bite. The first casualties were countries with large amounts of dollar-denominated government and corporate debt such as Turkey and Argentina. If a country borrows in a foreign currency, declines in local currency translate into proportional increases in debt levels. The 1990s saw a rolling series of spectacular economic collapses resulting from these dynamics, beginning with Mexico in 1994, followed by the Southeast Asian economies in 1997 and culminating with Russian 1998. Most emerging economies learned from this experience and the 2000s saw liquid markets develop for local -currency denominated debt, removing the need for most governments to borrow heavily in foreign currency. Only a few countries now have significant foreign currency government borrowings – for the MSCI Emerging Markets Index, the average, market cap weighted percentage of government debt denominated in a foreign currency is about 5%. During the 1997 Asian Financial Crisis, countries had nearly all their government debt denominated in dollars. Only three countries of meaningful weight in the MSCI Emerging Markets Index have foreign currency debt accounting for more than a third of total government debt: Indonesia, The Philippines and Turkey. These three countries combined comprise less than 4% of the index market capitalization. Despite some recent headlines to the contrary, we do not see a repeat of 1990s-style financial crises to be a significant risk.

Concerns over trade wars with the European Union, Canada and Mexico waned as the Trump Administration obtained small concessions in revamped trade agreements and then declared victory. While a similar result may occur with China, the situation is more complicated. The administration views China as a strategic adversary and recent news of the country inserting a small ‘hacking’ chip into servers used by top American companies such as Amazon’s cloud services supports this belief. The consensus opinion surrounding China’s 2001 admission to the World Trade Organization was that economic growth and trade would necessarily be accompanied by gradual political liberalization and convergence with the geopolitical interests of the US and Europe. While China’s subsequent economic growth and integration into global supply chains exceeded expectations, the Chinese Communist Party rules at least as tightly controlled authoritarian state as it did at the turn of the century. Given these dynamics, a protracted ‘trade war’ with China is more likely than it was with either the European Union or the US’s North American trading partners. However, China’s economy has been weakening lately and the country remains more dependent on exports than the US. While an authoritarian state, the Chinese Communist Party relies on delivering a consistently rising standard of living to maintain its political legitimacy.

Over the past decade, China doubled the size of its economy, but quadrupled the debt in its banking system, adding $29 trillion of new loans. Observers have long noted the unsustainability of the country’s debt-funded investment-driven economic model. During the early stages of China’s boom, debt supported tremendous levels of productivity growth as the starting point was an impoverished Maoist agrarian state. In 1978, 71% of China’s workforce struggled in sustenance agriculture, which declined to 51% in 1995 and 27% by 2017. This freed hundreds of millions of Chinese to perform more productive work. A high savings rate and adoption of the export -driven development model pioneered by first Japan then South Korea translated into ample capital for the tightly state controlled banking system to direct into productivity -enhancing infrastructure projects. However, over the last several years, demographics have changed and China’s workforce is no longer growing. The high past level of investment means that new infrastructure investments will bring little incremental productivity benefit. China’s corporate debt level now exceeds 160% of GDP. By comparison, corporate debt recently hit an all-time high in the US of 72% of GDP. Recognizing these risks, China’s leaders began taking steps to reform the financial system in 2015, but every possible solution to the problem involves unappealing tradeoffs and the corporate debt levels have continued to rise, although the government has had some success in shrinking the riskiest parts of the shadow banking system.

Investors generally do a poor job timing entry and exit points in emerging markets. After the rolling financial crises of the 1990s, emerging markets were widely hated in the early 2000s when they began their decade of double-digit outperformance. By 2010, it was common to see large emerging market positions in institutional portfolios. For example, the Harvard Endowment had a target of 11% of its total portfolio for emerging market equity, which translated to approximately one-third of its total publicly traded stock portfolio1. By 2016, this target allocation had increased to nearly 40% of the endowment’s allocation to public equity. Contrarily, in 2010 Yale had 14% of its publicly traded equity portfolio in emerging markets about a world market weight at that time. By 2017, Yale found more value in the sector, and allocated 8.5% of its Endowment to emerging markets, representing over 40% of its public equity portfolio. Similarly, Stanford recently increased its allocation to emerging markets by 25%, from 8% of its total portfolio to 10%2.

While emerging market valuations are compelling relative to US stocks, late cycle risks make us wary of overweighting portfolios; however, selling now could be an expensive mistake. It may be this slowdown has already reached its trough, setting the stage for a strong recovery next year. Strong growth in the US and better growth in Europe would provide support for this recovery. Under this scenario, emerging market stocks would likely rebound, providing returns comparable to the 30% + gains in 2017. Alternatively, with the US economic expansion entering its tenth year and in the midst of a Fed tightening cycle, there is a risk that the US economy slows, potentially due to the Federal Reserve over-tightening monetary policy. Emerging market stocks would fare poorly, likely underperforming US stocks as they have in past bear markets. A Chinese recession and potential financial crisis lingers as the most significant risk to both emerging markets and the global economy. Nearly a decade of failed predictions have perhaps made investors too complacent of the risks within the Chinese financial system.

We have generally recommended emerging market allocations in line with global index weightings. The long-term secular thesis remains valid – most of the world’s middle-income population now resides in an emerging market, and this population is growing. Historically, periods when investors hate emerging markets have been good times to invest. Real, investable businesses exist in most of these markets. However, weaker corporate governance, political institutions and more volatile economic growth make emerging markets more volatile and economically sensitive than other areas of the equity market and we remain wary of increasing portfolio risks at this time.


1 Harvard Management Company Endowment Reports. 2010, 2016
2 Emerging Markets Equity: What Do They Know? Janus Henderson Investors March 2018


Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer


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