This year, emerging markets have run ahead of the S&P 500 after years of underperformance. Thanks to a declining dollar and continued monthly inflows, emerging markets have been a shining star in the 1st half of the year. Now the question is: will the trend continue? Let's take a quick look at a couple of charts.
Big laggard
Since the Great Recession, emerging markets have been a terrible place to invest. They are up just 12% over the last 5 years which is a huge letdown when the S&P 500 is up 95%. They have perked up since the beginning of 2015 and then up over 20% in 2017. Despite this rally, they are still lagging the S&P by a wide margin in the bull market cycle.
A longer term view
If we look back further to the launch of the iShares Emerging Markets ETF (EEM), we see that it had an incredible run from 2003 to 2007 and since then it has basically traded sideways. If you look at this longer term view, the S&P and EEM have virtually the same return over the last 15 years. Perhaps EEM had gotten ahead of itself and now they are basically trading in tandem.
The bull case
Emerging markets are looking especially interesting because their valuations look cheaper than the developed markets. If you look at almost any valuation metric like CAPE ratio, emerging markets are trading at 15.6x vs developed markets of 23.4x. Of course you could have said that for several years now so value only tells part of the story. One reason for the shift may because the central banks are starting to tighten on the margin. After years of quantitative easing in the developed markets, the US is leading the way to shift off emergency levels by raising interest rates and intentions to reduce the Fed's massive balance sheet. So while the advanced economies return to normalized monetary policy, global investment firms are looking for an opportunity where valuations are more attractive and risk levels are relatively low. This is leading them to evaluate emerging markets where GDP growth rates are higher and debt levels are much lower as well. We are finding China especially attractive but many of the Asian markets also are beneficiaries of the rise of China. EEM is a bet on Asia with roughly 70% weighting in Asian economies and 27.7% in China alone.
