Over two centuries ago, famed British banker Nathan Mayer Rothschild coined the trading phrase, “buy on the sound of cannons; sell on the sound of trumpets.” He was insinuating that markets tend to panic at the outbreak of wars (“the sound of cannons”), presenting good long-term values. On the other hand, markets typically become sanguine once a conflict comes to an end (“the sound of trumpets”), driving them to elevated levels where traders may want to consider selling.
So, what to do with emerging equities? Do we hear cannons yet? For example, all the rhetoric about a trade war has pushed China’s domestic market into official bear market territory this week. The Shanghai index fell below 2,800 for the first time in two years and is now down roughly 22% from its January peak, as you can see below.
Likewise, the broad based emerging market ETF (EEM) is down almost 19% from its peak on January 26th.
Emerging market currencies have also been slammed. The JP Morgan EM currency index is off a cool 11% since January.
The list of reasons for such performance is well known, but the big three are:
- It’s hard not to put trade war fears at the top of the list.
- Then there is Fed policy. More rate hikes and quantitative tightening are a double-barreled blow as liquidity becomes tighter.
- A related point concerns the dollar. A strong dollar is a problem for countries with a lot of dollar denominated debt. Yes Turkey, we are looking at you!
Once again, does all this pain signal a buying opportunity for investors? Over the short-term maybe not. If the Fed continues to tighten through the end of the year then the trend of tighter liquidity and a strengthening dollar could persist. Both would be a headwind for EM.
However, longer-term investors may be hearing the faint sounds of cannons. Take the following article from Research Affiliates that was published this week. They lay out the case why the recent hints of panic may offer a buying opportunity for those with a time horizon beyond the next quarter or two. Their argument rests on two foundations:
1) The risks of a funding crisis in most EM countries is low. Based on their analysis, “60% of the EM asset class face little if any risk of a funding crisis.”
2) EM equities have fully pricing in the macro risks. Today EM equities are priced at less than half of US equities (based on the CAPE ratio.
The key quote from the article:
“Fear of emerging markets seems more elevated today than at any time since the early 2016 EM lows. Remarkably, even after EM stocks have delivered nearly a 100% total return from those lows, they remain comparatively cheap when measured by CAPE, price-to-book ratio, price-to-sales ratio, market cap to GDP, and other metrics. When the risks and the bad news are well known to the market and fear reigns supreme, it’s time to buy, not sell.”
Whether you agree with them or not, their view is worth considering before making drastic allocation moves.
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