Bottom Fishing-2: Emerging markets

Each cloud has its lining, as we often say, and this applies to investing more than anything else. Market drops often present buying opportunities, but only if you have the courage, patience and perseverance of a true long-term investor. Last week, we discussed European equities as a potential opportunity for bargain hunters. This week, we move on to emerging markets, which has been one of the worst performing categories so far this year.

As of October 31, the Dow Jones Emerging Markets Index was 11% down (in Canadian Dollars terms). Such weakeness is atributed to several factors. Trade war rhetoric has been one of the major issues, for sure, but there are other structural considerations, particularly for China. Primarily, Chinese econmomic growth has slowed down to the 6%-7% range, and that is if you believe Chinese numbers. Several economists believe the actual numbers are worse than that. But for China, a 6% or 7% growth is low, given people are used to 10%.

Mounting domestic debt, and the poor quality of bank loans, remain a major structural problem in China. Another major concern is excess capacity. Many Chinese projects are politically driven without being economically viable.

To address its structural problems, China needs time. But it also needs its export market to gradually absorb the negative impact of structural reform. And, on that front, trade tensions with the US only make things worse.

Lower commodity prices represent another negative factor for emerging markets. Indonesia, Malaysia and several Latin American countries are largely dependant on commodity prices. And given China is a major consumer of commodities, slowing demand from there is affecting the prices of iron ore, copper and several other industrial commodities. As for oil, it has its own excess capacity problem, driven by increased production from both Saudi Arabia and US shale.

Is it time to get into emerging equities, or would you be catching a falling knife? One thing that is likely to give the market at least a temporary boost is the tentative agreement between the US and China to halt trade war escalation for 90 days. This will very likely give global equities a much needed break. If a major rally does not come out of this, at least a slow down in the emerging bear market momentum is quite likely.

Another slightly positive development is the recent Fed announcement that interest rates have now reached "just below normal levels...". This is most probably a first signal by the Fed that monetary tightening is approaching the end. It does not exclude two or three more interest rate hikes, but at least it signals that this monetary tightening cycle will end sometime in the first half of 2019. Higher US rates have also been a major risk factor for all equity markets, so once this cloud clears, equity investors across the globe will feel better.

All things considered, investing in emerging market equities at this juncture does require, among other things:

First, a strong belief that China is not, after all, falling apart, and that much of the current negatives has already been reflected in the 20% or so drop in Chinese equities. To put things in perspective, China is the second largest world economy. One big advantage of non-market economies is that problems can often be solved without Mr. Market's help. For example, a loan will never become bad unless the borrower claims it, and for government-owned Chinese banks, the government will make sure that many loans, if not repaid, will never be claimed (it sounds unorthodox but that's how China has operated for decades). Moreover, China has geopolitical/economic ambitions that will require heavy infrastructure spending both at home and in surrounding countries. All such projects will require a lot of energy, steel, copper and many other commodities to be completed. In other words, there will be a turnaround sometime down the road.

Second, a strong belief that China and the US will eventually find a way to resolve their disagreements (just as Japan and the US did when they faced similar issues in the seventies). The road will be bumpy and solutions will take time, but a total collapse of global trade will not happen because it is in nobody's interest.

Third, a strong belief that commodity prices are cyclical, and that low prices eventually lead to lower capacity and subsequently to price rebounds. An eventual rebound in commodity prices will inevitably drive emerging equities higher.

Despite your strongest beliefs, timing is always an issue. On that, we suggest you be guided by three famous quotes:

"the proper response lies in contrarian behavior: buy when they hate ‘em, and sell when they love ‘em." This quote, by Howard Marks, simply means that you should not wait for the good news in order to start investing in emerging markets because by then, the market will already have made its first big move. Markets move in anticipation, not after the fact.

"A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates." This one, also by Howard Marks, is self explanatory. But the main idea is to make sure you are comfortable with the risk you are taking and how much of it you can afford. Guessing market moves is impossible and one has to always be prepared for the worst.

"Being right but being early simply means that you are wrong": if you get into emerging markets too early, and the market loses another 20%, you will not be pleased with the result. This is why, despite your strongest beliefs, we would never advocate putting too much of your eggnest in any single asset class or market, or putting it all together in one single jump. To the contrary, we prefer that you go in in small increments of additional exposure by capitalizing on market drops like this one. Timing and how much you put in emerging equities is something you should discuss with your investment advisor, who can provide personalized recommendations based on your objectives and personal circumstances.

The FundScope Choice selection features a handful of interesting emerging equity funds which share common features, namely: superior returns on a risk-adjusted basis and lower volatility versus a simple emerging markets index fund. Check them out by clicking here

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Have a good month!

December 3, 2018

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