Remember that almost all investors exhibit a “home bias” while things are going bad where you are, they could actually be going not that bad in other places or at least they would be on the uptrend. It helps to keep this in mind when looking at the current state of the markets in dollars and here in the US.
The hot issue right now is inflation in the rich world. Although some of this can be attributed to supply chain disruption, in the US the blame can be placed squarely on the Fed. Apologists for Fed policy have pointed out that Euro zone inflation hit 7.5% in March and 7% in Britain but if you strip out energy and food prices, inflation in those areas is 3% while if you do the same in the US, where inflation hit 8.5% in March overall, inflation is still 6.5%.
The Fed seems to be of the opinion that inflation can come back down to its implicit target of 2% if they raise rates to 2-2.5%, and markets seem to agree with them. Yet there is some evidence that suggests that in order to truly stamp out inflation the Fed may have to raise rates above the “neutral” rate for a period of time. This level is thought to be 2-3%, meaning that short term rates could find themselves at 4-5% if the Fed even has the resolve to kill off inflation by putting rates at that level. Rates like those have not been seen in the US for over 15 years.
This could induce a serious recession in the US and would cause problems for other countries as well. The yield on dollar assets, especially fixed income assets, has a strong pull on the value of the dollar. Think of it from a dollar investor’s perspective: if I am judged by my dollar returns and I can earn a 5% guaranteed return in dollars versus a risky return in Reais or Rand, why take the currency risk of the emerging countries? This provides an incentive for big institutional investors to ditch emerging currencies and convert those assets back to dollars.
Despite these factors looming over developing market returns, there are a few strong factors playing into favor in overseas markets that investors may want to take a look at.
Where Returns are Picking Up: An Example
The first is the rotation into value. The Vanguard value ETF (VTV) has returned -1.23% this year while the Vanguard S&P 500 ETF (VOO) has lost 10.29%. The fixed income side has fared little better with the iShares 20+ Treasury ETF (TLT) down 19.03%, it’s counterpart in investment grade bonds (LQD) is down 14% and Junk Bonds (JNK) have seen a 9% fall. The Japanese, Chinese, and European markets are not faring much better, falling 15%, 19% and 10.5% respectively as measured through their respective ETF’s offered by iShares.
The second is the strength of commodity and energy markets. The winning investments so far this year are not surprisingly, in energy. The highest performing ETF has been BOIL which invests in natural gas futures contracts and has seen its value rise 180% this year. Yet there were a lot of factors you would have had to envision to see that investment payoff in January including the invasion of Ukraine. If we go outside of energy however, there is an interesting development in that the first investible national market we run into in terms of year to date returns is Brazil, which has returned 23.8% year to date and had returned at one time as high as 43% in early April. This has been mostly on the back of mining company Vale as well as state oil producer Petrobras, which combined make up about 30% of this ETF but it has also been on the back of the strengthening real. The central bank has risen rates from 2% to 11.75% in the course of about a year to fight off inflation.
And this has produced a rally in the value of the Brazilian Real
Keep in mind that currency appreciation matters in foreign markets because it has a multiplicative effect: return = market return x currency return, so although the underlying index the Bovespa, has rallied only about 6% this year, the 16.6% return in the real means that returns for USD investors are: 1.166 x 1.06 = 1.235 -1 = 23.5% or about the 23.8% return that we would have seen by investing in that Brazil ETF from iShares.
If you think the rally has sputtered out here, keep in mind that the real is still relatively weak on a historical basis and as recently as 2017, was around 3 to a dollar as opposed to the 4.80 it is at now. Were it to appreciate to a similar level, that could mean a 34% appreciation in the currency multiplied by whatever return we see in the Bovespa.
It’s not just Brazil, a few other markets overseas have been quietly producing great returns this year, although with a high amount of risk associated with them due to the political situation or their moribund running of the economy.
Where Else Things Are Heating Up
I regularly check in on a great blog by NYU business professor and CIO of Sycamore Capital, Jean van de Walle called simply theemergingmarketinvestor.com Mr. van de Walle regularly looks at the long term valuations across emerging markets and a recent list of markets which are cheap compared to their historical CAPE ratios and their expected returns was shared:
At the top in terms of cheapest valuations are Turkey and Chile, both of which are undergoing uncertain political change. Beyond that, Brazil, China and South Africa all are projected to offer annual returns over 8% for the next 7 years based on GDP growth and valuation with no earnings multiplier taken into account, which usually tends to rise as investors crowd into trendy trades.
Turkey is a risky example of how picking the most beaten down markets can sometimes pay off. The iShares Turkey ETF is up 22.6% year to date after nosediving in late 2021 on the firing of its competent central banker and its president’s skepticism towards higher rates reducing inflation. Inflation hit a 20 year high of over 50% in March yet many observers don’t realize that Turkey is a market which has survived with inflation of 40-50% annually for decades on end. Right through the 70’s, 80’s and 90’s the country experienced coups and high inflation, yet investments there didn’t do……terrible. Admittedly I don’t know much behind the fundamentals of the rally in Turkey other than it is seeing a growing presence of Turkish Airlines and some mining companies are doing well. What I do know a little better is what is driving the rallies in Latin America and South Africa.
These countries all have something in common: they have established democracies, despite some recent polarization, they are far way from the conflict in Ukraine and they tend to be commodity exporters. Even after the Russian invasion, Latin American equity markets led emerging markets in terms of return due to this luck factor.
For those that are willing to take the risk, I would argue that Chile, Brazil, South Africa, Colombia and potentially Peru could lead the pack in emerging market returns due to these factors. For those that are really looking for risk they could play their hand in Turkey and China. I personally am a bit averse to China because most large global emerging market portfolios already have a sizable exposure to China and I don’t yet think it deserves overweighting. In contrast, the smaller Latin markets and South Africa have the prospect for appreciating currencies and benefitting from the commodities boom.
As always, investors should keep in mind that these markets are volatile and prone to sudden shifts in geopolitics and investor sentiment. An abrupt downturn in the world economy, dramatically higher interest rates in the US or a sudden shift in investor risk appetite could all have sudden negative effects on these names. Don’t be afraid to leave the US in search of returns, but know your risks and your risk tolerance if you do.
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