When looking at the year ahead, an otherwise gloomy Jeff Gundlach last week found a rare spot of optimism within emerging markets, which have outperformed global indices and, according to Gundlach, that’s where investors should put their money “over the next seven and certainly the next 20 years.”
In his Dec. 11 webcast, Gundlach noted that the cyclically adjusted price-earnings (CAPE) ratio for emerging-market stocks is less than half that of the S&P 500. But, in the last two decades, there were times when it was much higher. Based on that metric alone, Gundlach said emerging-market equities could outperform U.S. stocks by 100%.
Gundlach is not alone: in a recent interview, GMO Chairman Jeremy Grantham reiterated his positive outlook for emerging markets saying “There is very little chance that you’ll come back in 10 or 20 years and emerging will not have beaten the pants off the U.S.,” Grantham said. And Rob Arnott of Research Affiliates and Mark Mobius, who recently retired from Templeton Investments, have also predicted outperformance for emerging markets.
Others however disagree, among them those who correctly predicted the 2018 crash in emerging markets. One such skeptic is SocGen’s Jason Daw, who warns that some of the world’s biggest investors are setting themselves up for a major disappointment.
The Singapore-based strategist was one of the few to anticipate the slump in emerging markets beginning in January; fast forward one year when Daw once again sees no imminent turnaround for the asset class. According to Daw, the modest rally in currencies since September, led by Turkey’s lira, Brazil’s real and South Africa’s rand, is temporary and that slower global growth and additional tightening by the Federal Reserve will continue to weaken developing-nation currencies.
“It will be a multi-year process for investment behavior to adapt to less generous dollar liquidity conditions after a decade of easy money,” he said. “The hurdle for capital to flow back into emerging markets is high and a significant macro catalyst is required to turn the narrative around.”
Of course, one such catalyst is for the Fed to announce it is cutting rates, or perhaps even launching QE, but before that happens the US economy will have to get far worse before Jerome Powell capitulates on the Fed’s 3 rate hikes for 2019 dot plot.
Until then, Daw is among a cadre of contrarians including Man GLG money manager Lisa Chua, Bank of America strategist David Woo and Harvard economist Carmen Reinhart who take the other side of the Gundlach/Grantham/Mobius trade, and warn of additional risks for emerging markets, even after eight consecutive weeks of inflows into the asset class according to Bloomberg. Specifically, they say to ignore the fund flows and focus on economic fundamentals, namely the gloomier growth outlook amid an escalating trade war, the prospect of further dollar strength as well as pockets of fragility in China, Brazil and India.
That would compound the pain from an already tumultuous 2018 in which emerging-market equities slid into a bear market and every major currency in the developing world declined against the dollar.
Of course, there is the possibility that the skeptics are wrong as some combination of Chinese stimulus, an end to the U.S.-China trade war, a pause in Fed tightening due to inflation and higher oil prices could help spur a rebound within the EM asset class according to Daw. However, so far few of these appear imminent.
Yet while bears agree that emerging markets will see continued selling in 2019, they’re split on what will be the primary source of pain.
Take the main who correctly called the EM action this year: according to ScGen’s Daw, the time to get back in emerging-market assets would be when the Fed starts to cut rates, and that could be 18 months away.
“I get the feeling consensus is on the more optimistic side,” he said. “We have believed that EM FX could weaken since the end of last year.”
He sees some value in Argentina, which led emerging-market currency declines this year. The Societe Generale strategist also recommends shorting the Brazilian real against Mexico’s peso as the initial market euphoria following Jair Bolsonaro’s election wanes.
Meanwhile, as we reported previously, the biggest concern for BofA’s head of global rates, David Woo, is that Xi Jinping’s government has no incentive to make concessions on trade, especially with Donald Trump hobbled by congressional gridlock. Domestically, Chinese authorities must juggle the need for stimulus with the desire to rein in runaway home prices. Woo recommends shorting the Indian rupee and Mexican peso as the slowdown in China weighs on assets across the developing world.
“You want to buy EM?” he said. “I wouldn’t touch EM with a 10-foot pole until there’s a resolution between the U.S. and China.”
At the same time, Ecstrat founder and China bear, John-Paul Smith, said he’s confident that a slowdown will hurt emerging-market equities. He recommends being underweight or zero-weight Chinese shares, Russian stocks and South Korea’s won, given their sensitivity to trade and commodities.
“I expect all three to have significant downside in dollar terms between now and the end of 2019,” Smith said.
Last but not least, there is the biggest reason of them all to be short EMs: the dollar is strong – in fact it is just shy of 2018 highs – and will likely remain strong for the foreseeable future even as bears continue to rise, expecting the dollar to tumble as the Fed suggests its rate hiking cycle is over. According to Schwab’s Kathy Jones, “it’s best to remain underweight emerging-market bonds as spreads potentially widen to 450 basis points over U.S. Treasuries.” She also expects the dollar to remain strong in the near term, while additional Fed tightening, slowing Chinese growth and lower commodity prices also prevent a big rally.
“There is a case for a rebound in EM sometime in 2019 once the peak in tightening financial conditions has been reached,” Jones said. “We just aren’t seeing it in the near term.”
We now eagerly look forward to the EM bulls’ response. And considering that Gundlach is among them, we won’t have long to wait.