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Should I Own Emerging Markets Now?

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Written by: Gabriela Santos

After ending 2018 at the very bottom of the returns table with a negative return of 14.2%, emerging market (EM) equities have had a strong start to the year. EM equities’ positive return of 8.8% over the month of January places it back at the top of the table. This is an excellent reminder that fortunes can turn very quickly for EM assets and trying to time that turning point can be very tricky for investors.

In the short-term, EM equity performance can swing wildly, as recently witnessed, due to big changes in investor sentiment towards the asset class. Last year, sentiment soured rapidly due to many uncertainties around trade, Chinese economic growth, Federal Reserve rate hikes, and the resulting U.S. dollar strength. Looking at the drivers of EM return last year, it is clear that the turn in investor confidence was the main culprit for the negative performance, with multiples contracting and currencies weakening relative to the U.S. dollar.

Fast forward to this year, the exact opposite has occurred, with an improvement in investor confidence leading to multiple expansion and currency strength relative to the U.S. dollar. While important question marks still hang in the air, investors have been cheered (for good reason) by the trade cease-fire between the U.S. and China, the various stimulus measures enacted by the Chinese government which should prevent a “hard landing” in its economy, and the very dovish turn taken by the Federal Reserve.

In the short-term, these big swings in investor sentiment rock the EM boat; however, longer term these waves end up fading from view and the destination is driven by fundamentals, not by sentiment. Looking at EM equities’ annualized return over the last 15 years, multiples and currencies had a negligible contribution to return over this time period. Instead, the bulk of returns came from dividends and earnings, the fundamentals.

Related: Eyeing Alternatives With A Managed Futures ETF

Related: Why Rules Matter With Emerging Markets Investments

Over the past 15 years, these positive fundamentals led to an annualized return of 8.3% for the MSCI EM Index. However, it unlikely that all investors actually experienced these kind of returns themselves. More often than not, investors try to time investing in EM, with devastating results. Given how close the best days are to the worst days, this strategy is likely to result in investors’ missing some of the best days for the asset class. If an investor had missed the 10 best days, their return would have been cut by more than half to only 3.5% over this time period.

Thinking about the next 15 years, EM equities should continue to provide higher returns than those in the U.S., driven by more favorable demographics and much higher revenue growth. However, in order for investors to see these returns reflected in their own statements and not just on the data screen, it will be crucial to resist the urge to jump on and off the boat when the waves are crashing. To avoid seasickness, the best thing to do is to keep an eye on the horizon – one which is looking bright for EM.

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