June 1st kicked off a new month of investing and a look back at performance in the month of May can be telling for how the popular narrative can be way off actual performance.
Below are the top performing ETF’s for the previous month. Gold, silver and energy dominated returns this month as commodities continued their surge with a strong global rebound and inflation fears carrying expectations.
The big surprise for those new to investing in the past year is the sharp drop across the board in crypto. With zero fundamentals other than the greater fool theory supporting crypto prices, it was only a matter of time before another correction reared its head. With Bitcoin falling 35% for the month of May we are now in the 3rd crypto bear market in the last 4 years, so much for being an inflation hedge. The return of Bitcoin year to date is still decent but less sexy than a stodgy old energy ETF at 24%. Ethereum remains the outlier. Despite its fall by as much as 50% in the last month, it is still up 260% for the the year.
Gold Ascendant
The inflation hedge as old as time also seems to be making a comeback, with gold up 7.4% in the last month and almost breaking even for the year. It seems investors forgot besides being an inflation hedge, gold actually has other uses in industrial uses, jewelry and electronics. Like any other commodity, it finally seems to be catching the price wave on the back of those inflation fears. This isn’t the first time this has happened with gold prices. When stock markets drop and gold doesn’t budge, many commentators claim that gold has decoupled as an inversely correlated asset. Yet there are other factors at play in gold demand which take time to take over. They could be demand in India, whose wealthy buy lots of gold for weddings, or it could be from central banks looking to gain a larger foothold in commodities to maintain the value of their reserves versus the dollar.
Emerging Markets Creeping Back
Yet apart from gold and silver there is a story within a story of those monthly returns. Since the beginning of the year I have been bullish on emerging markets as well as value stocks. At times they have disappointed me as tech shares had a brief day in the sun in late March and rising long term rates in the US pulled dollars back in from abroad earlier in the year, raising the dollar index. But now it seems that those medium term trends I had spoken of, mainly the weaker dollar as well as growth in commodity producing countries is starting to bear fruit.
Of the list of best performing ETF’s above, you may notice that emerging markets make up 7 of those funds. Brazil is featured in 2 of them and others include small cap and consumer plays. In a way, this is a repeat of a story we have seen play out only in the past year in places like the US. That story is one of value and small cap stocks outperforming the overall market.
Brazil and other emerging markets, especially those in Latin America, have been hammered by Covid. They suffered severe lockdowns, poor government response and have been slow to emerge from lockdown as well as keeping a lid on the virus through vaccination. Yet as the vaccine is slowly distributed, there is starting to be light at the end of the tunnel. Combine this with rising interest rates in places like Brazil, pulling investors back in who are searching for any type of fixed income return and you have a recipe for a cyclical comeback in stocks as well as an appreciating currency. Economies in many emerging markets are often dominated by cyclical old economy stocks such as oil & gas and mining companies. It’s logical that many of the countries rich in things like oil would have done well last month along with the general energy upswing.
Yet when the economy gets battered, it’s also the high beta stocks that get beaten down the most, and these are more often than not small cap stocks. Within most emerging markets since the beginning of 2021, small cap stocks have been beating returns of large cap stocks handily, in the case of Brazil this is by 25% in the past year but has really started to take hold since February of 2021.
The small cap outperformance can be expected to persist well into 2022 in many markets as the recovery and emergence from the virus gain momentum. The analogous trade in the US that has happened over the same time is the outperformance of the small and mid cap infused Russel 2000 over the past year which is up 63% during that period while the large cap S&P 500 is up 37%. We are literally watching this cycle repeat in emerging markets and it may yet still have legs except for places like China where they seem to be in a later phase of their expansion and are already talking about tightening.
Complications With Foreign Stocks
For those who may be new to foreign stocks, there is an added factor of the dollar denominated returns of your investments. Even if a stock market does fantastic, as Brazil’s have done since it’s recession in 2015, currency depreciation can negate almost all the return when converted back to dollars.
Most of the ETF’s that are country specific are unhedged, meaning they will incur currency risk as well as equity risk and in the case of Brazil, what killed returns previously, is starting to provide a huge boost to it now.
It’s all based on interest rates and for years Brazil had some of the highest of any relatively low inflation emerging market. But the recession of 2015 saw the central bank cut rates dramatically, which helped boost the economy but also saw the currency depreciate just as dramatically. Now that policy has been reversed and higher than expected inflation is pushing the central bank to raise rates quickly, attracting back much of the foreign capital back and appreciating the real as well. The target rate set by the central bank reached a low of 2% in August of 2020 but has now risen to 3.5% and is expected to move higher as inflation expectations hit 5.3%, well above the target of 3.75% set by the central bank. That leaves a lot of room for higher rates. Investors seem to be positive on the credibility of the central bank towards fighting inflation and have thus increased demand for Brazilian bonds and the real on the back of this.
Advanced Advancing
Even advanced economies are benefitting from the opening and the appreciation in their currencies. Despite pairing back my bet on the UK stock market, I still have a position there and have watched it beat the S&P 500 over the past 2 months returning 7.5% compared to a 4.8% return for the S&P. This is primarily due to the heavy “old economy” stock weighting in the FTSE which has a high proportion of energy and banking stocks which have handily outperformed over the past few months. Yet it has been helped by the 2.4% appreciation of the pound versus the dollar over the same period as well.
While commentators focus on oil and commodity prices as inflation hedges, the critical story of currencies versus the dollar has been little spoken of. The US remains an outlier in terms of the size of its fiscal and monetary stimulus, which should produce a medium term fall in the US dollar. This is exactly what we have been seeing since late last year with an exception of the March bump in the dollar as long term rates perked up.
When the dollar falls, foreign assets prices increase in value in dollar terms. Combine the falling dollar with the recovery from the virus as well as reopening and there is a strong case that foreign assets will continue to outperform conventional US assets into the next year.
If this turns out to be true, it just adds fuel to the notion that we should remain diversified because the market surprises even the best of us. It’s ok to make strategic bets on sectors or even crypto with a portion of your portfolio but an all US allocation to stocks and bonds will definitely drag down returns over the long run as the dollar’s continued strength is not a given. The world may be changing fast and tech ruling the world, but the old economy has something to say on returns before it gives up the ghost.
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