The surface of the Earth moves on tectonic plates. So, too, it seems, do the emerging markets—where economic opportunities (“There’s a growing taste for whisky in Brazil”) often get swept under deeper, more profound realities (“Who cares? The country’s oil is too cheap and its president is about to be impeached.”)
That leaves everyone watching the big waves either for signs of tsunamis or for surfing conditions, and the markets earlier this year provided the latter. The MSCI Emerging Markets Index rallied 24% between January 21 and April 19, 2016.
The beginning of a bigger rally? The end of a trough? Not so fast. A team at Goldman Sachs said that, despite whatever happens inside these very dissimilar, variegated countries, their performance is right now being distorted by macroeconomic trends. The team, led by Caesar Maasry, wrote on March 8 that the rally was getting an artificial high from a softening dollar (which makes emerging assets and currencies more attractive), firming oil prices and a surprisingly mild tone from the U.S. Federal Reserve about future interest rate hikes.
“Specifically, the commodity-heavy EMs (Brazil, Russia, Chile, South Africa) have been the best performers amid the rally in commodity prices,” wrote Maasry and his team.
According to Goldman Sachs, the last 15 years (covering the most recent bull and bear cycles) have seen a close correlation between EM equity and commodity prices (especially oil). Those macroeconomic distortions cover up familiar problems: China’s growth is softening and it’s the biggest, fattest elephant in the index. Many countries also have to clean their credit houses, and there’s wan demand from slowing developing markets.
Worse yet, the team wrote in early May, emerging market earnings per share, after China and commodities are taken out of the picture, were “flat from end-2011 through mid-2014 ($56 to $57) and has since declined by 13% to $50. In short, [earnings per share] weakness appears not to be simply a commodity or China issue.”
But active managers make the case that after the index’s decline last year (a drop of almost 15%) there are bargains here—oversold companies unfairly abandoned and neglected after the market decline. There are, the managers say, companies that are really cheap, if only you know where to look for them.
“Countries like Brazil and Russia have had very bad years for the past few years, so in some sense [the rally was] a correction,” says Patricia Oey, an analyst at Morningstar. “The macro environment has been getting better and these markets were super-cheap. Russia was trading at low mid-single-digit P-Es. So there can be a balance when sentiment improves.”
The rally, thus, has favored value plays, she says, companies that had previously been deadweights in the index. And so Morningstar’s top funds for the year as of April 26, 2016, had a value tilt (and for that saw double-digit returns). The top five, Oey says, were the PIMCO RAE Fundamental PLUS EMG fund, the Invesco Developing Markets fund, the WisdomTree Emerging Markets High Dividend ETF, the PIMCO RAE Low Volatility Emerging Market Fund and the Lazard Emerging Markets Equity fund. A brief scan of their tickers indicates these funds were pulling 15% to 19% returns for the first four months of the year. And Brazil represented 16% of the Invesco fund, she says, while WisdomTree and Lazard had almost 10% Brazil (it’s closer to 6.5% in the MSCI index). South Africa, a battered commodity play, also had higher-than-average allocations in a couple of funds, Oey says.
It’s very telling, however, that the better long-term performance plays—those that outperformed over the past five years (not three months) are not only completely different, but have swept the bottom in 2016. That includes the five- and four-star Morningstar names such Virtus Emerging Markets Opportunities fund (HIEMX), American Funds New World (NEWFX), the EGShares Emerging Markets Consumer fund (ECON) and the Thornburg Developing World Fund (THDAX). “All these guys are kind of at the bottom of the list year to date,” Oey says.