Traders have seen a sea of red around the globe in 2018 as the MSCI indexes for both emerging and developed markets fell by double-digits through the end of November, according to Yardeni Research. The worst offenders include German, Mexican, Chinese, South African and South Korean stocks, which all are off roughly 20 percent in dollar terms.
Foreign markets have been by hit by a sort of perfect storm, suggests Chris Dhanraj, the head of iShares investment strategy for the U.S. ETF business. “Part of it is due to trade worries, but there have also been challenging elections, tightening financial conditions and the strength of the U.S. dollar,” he says.
If you’re wondering why the typically strong German economy should fall so quickly out of favor compared to the U.S., consider the impact that trade wars have had on export-focused economies. Companies listed in Germany’s DAX derive around 80 percent of sales outside of Germany, compared to 37 percent outside of the U.S. for the S&P 500, according to FactSet.
But 2018 wasn’t an outlier for weaker offshore returns. International stocks have lagged their domestic counterparts for quite some time. The MSCI All-World Country Index (ex-U.S.) has returned 8.3 percent per year over the past decade, according to Morningstar. That badly trails the 13.9 percent yearly return for the S&P 500.
The silver lining to that underperformance is that valuations are often more attractive in other markets versus our own. In China, for example, the forward earnings multiple on the MCSI China Index has fallen to 10.3, less than 60 percent of its 10-year average, according to Morgan Stanley. That compares to a forward multiple of around 17 for the S&P 500. Morgan Stanley strategists recently recommended that investors underweight U.S. equities and rotate funds elsewhere because equities outside the U.S. are “exceptionally cheap.”
Dhanraj and his team at iShares suggest that investors need to be selective. They favor China and India, while recommending an underweight position in Europe and a neutral weighting in Japan.
They say emerging markets hold especially strong appeal right now. “They have the best valuations in place across all markets right now,” Dhanraj says, adding that the earnings yield across emerging markets has risen to 10 percent. In response, fund flows are surging back towards emerging markets. The $23.9 billion in net inflows into Asian emerging markets in November was the strongest since January, says the Institute of International Finance.
Investors who still perceive emerging markets to be too risky and volatile may want to consider the iShares Edge MSCI Min Vol Emerging Markets ETF (EEMV), which has fallen less than five percent year-to-date compared to a 12 percent drop in the iShares MSCI Emerging Markets ETF (EEM). As discussed a few weeks ago, low volatility funds have been a savvy approach in the current market environment.
In that vein, the EEMV reduced volatility fund’s nearly two percent annual return over the past five years is nearly a percentage point higher than the return on the unconstrained EEM fund. Perhaps some of that differential can be explained in the cost structure of these two funds: EEMV has a 0.25 percent expense ratio versus 0.69 percent for EEM.
Rather than focusing on specific companies or regions that might deliver the best rebounds in 2018, it may be wiser to focus investment strategies based on long-term thematic trends. One such trend is the growing middle-class consumption in emerging markets.