One of the biggest arguments for emerging markets during their bull market, which started in 2003, was about “decoupling”. The idea was that the emerging markets had now managed to decouple from the developed world, and would be impervious to a recession there. It never worked as it was supposed to, with the arguable exception of a few hectic months at the end of 2008 when China’s stimulus appeared to end. Now, I’d argue, the decoupling has ended, but not in a good way.
I discussed emerging markets with Barclays’ Larry Kantor in a Note video. That included the following chart, which shows that emerging markets have now underperformed the developed world over the last five years, a period that starts roughly with the crisis over Fannie Mae and Freddie Mac in the hot summer of 2008:
Significant EM underperformance when developed markets were performing well is a new experience for many currently operating in the markets. More detail (and charts) after the break.
Until 2003, emerging markets had performed much as theory would suggest. They had little in common with the developed world. During the 1990s they boomed and then bust in a succession of crises (from Mexico through south-east Asia and then back to Brazil and Argentina), all as the developed world enjoyed a historic bull market.
But starting in 2003, liquidity in the developed world, and optimism driven by the growth of China and the then newly minted “Bric” concept brought money flooding into emerging markets. But this was not as a hedge against the developed world, as would be implied by the “decoupling” rubric. It was more of a leveraged play on it. My favourite way to demonstrate this, borrowed from my book, shows the absolute performance of the MSCI World index (which despite its name is an index of developed markets), against its relative performance to the MSCI Emerging index. During the rally that started in 2002-03, these lines were inseparable – good news for the developed world was always even better news for EM.
The blue line here shows the absolute performance of developed markets, and the red line shows the relative outperformance of emerging markets.
This was of course exactly the opposite of the “decoupling” rubric. The better developed markets did, the even better emerging markets performed.
Then in October 2008, EM started outperforming the developed world, some five months before developed world stocks hit bottom. The risk of a vintage emerging markets crisis had been averted, through such measures as the provision of swaps lines by the Federal Reserve, and markets were impressed by the stimulus administered by China.
In March 2009, when the developed market rally started, the old trend resumed, with EM outperforming as the developed world did well. That pattern began to break down about two years ago, and in recent months it has broken down completely. EM is now seen as a decoupled entity with its own risks, not merely as a leveraged play on the developed world. The chart looks like this:
This is a big development. Most emerging markets are still sufficiently small that external flows dominate pricing. Is there value? Somewhere in the vast spaces of the emerging markets there must be – but trading it using ETFs as has been the vogue for the last decade is not the way to find bargains.
As for valuation as an asset class, EM is at present cheaper than at any time since 2005, as I pointed out on Monday. The full series, comparing price-to-book multiples of EM minus MSCI World.
Should EM trade at such a discount? If we return to a full-blown crisis to rival the late 1990s, plainly there is every chance that the discount could widen. Current valuations incorporate a sizable slab of risk that just such another crisis is coming down the pike, possibly to be combined with a liquidity crunch and hard landing in China.
More broadly, the concepts that underpinned the emerging markets rally are being called into question. At one point, the power of China, and the superior opportunities for EM companies to grow from a low base, were held to justify paying an outright premium for EM stocks. On a long-term basis, at any rate, those arguments still sound decent. There is a real chance of a much better buying opportunity before long, once the current wave of aversion to emerging markets has passed. But if the EM financial institutions have stiffened enough to avert a repeat of 1990s- style crises, which is the critical question which will soon be answered, then valuations are reaching the point where it is time to buy.