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An Opportunity is Emerging Again

The recent under performance of emerging market has many reasons why, which are important for arriving at a conclusion if the weakness should be bought or not. The reasons range from risk-off moves, trade war escalations, U.S. dollar appreciation, geopolitical tensions, debt strains and rising inflation to name a few. However, one area that would wave the caution flag would be signs of recessions in the emerging market space as well as the world in general. This warning sign is not flashing no matter how much people may scrutinize the marginal growth rates of the economy. Global nominal growth rates are running north of 6% and expected to maintain this level for the next 18 months while the previous five years had averaged 5.30%. Though nominal rates are rarely quoted anymore, they do have a frontal psychological impact that is often overlooked by analysts and economists who relegate this social science as witchcraft. Even on an inflation-adjusted basis, emerging market growth is expected to be in the 4.6%-5.1% range over the next two years, with the most robust growth coming from Asia.

The fear of trade war is more prevalent than in the past, and with dire headlines, one can hardly blame the investor. However, global trade topped out as a percentage of global GDP in 2008 and has been in a trading range which points to the full maturation of globalization. While this has been disinflationary for developed markets and economically stimulating for frontier markets to develop into emerging markets, it has had a lasting long-term impact of increasing the domestic consumption rate of emerging markets. The domestic consumption portion of an economy is more stable, economically speaking, and diversifies a country away from huge capital outflows, though it does not insulate them from them. As evidenced in the trade agreement with Mexico, much of the trade wars are more sabre rattling than a call to arms. We expect escalated threats and public hardline tactics to continue but will likely lead to further compromises and a more tolerable trading platform. This should unfurl the excess money hiding in the risk-off trade and go to places where value is most prevalent. Just as the low tide shows who may be naked, water also ultimately finds its level and so will the money held behind the “Wall of Worry.”

The value in the emerging market space is pronounced in the last quarter. Consider the following metrics on the MSCI Emerging Markets Index.

 

Q1 2018

Q2 2018

Price to Earnings

14.66

12.92

Price to book value

1.69

1.62

Price to sales

1.36

1.23

Price to cash flow

9.20

8.92

Source: Bloomberg | Q1=1st quarter, Q2=2nd quarter

Considering most markets are at premiums to long-term averages, the lack of premium in the emerging market space is quite pronounced.

Visually, Bloomberg had one of the more telling charts on the relative value of the emerging market space compared to the S&P 500. Recently there have been several periods of great underperformance in the emerging markets as the flight to safety had many stops in the last five years. Longer term, these were less pronounced. One can see that the level we are currently at has often led to outperformance in the following year.


Source: Bloomberg

Since the markets crossed the 20% correction level, a bear market has been triggered. However, as evidenced by the table below, since 1990, the average six-month and 12-month returns in emerging markets is quite pronounced. Though it is not without a few periods of further declines, those periods were denoted by two recessions and one stealth recession in 2015.


 

Since we don’t see the beginnings of a recession, a potential scenario in which the average rebounds in emerging markets seems appropriate barring any unforeseen event. Investing at times when headlines are negative and market moves are negative requires a bit of fortitude. However, without the fundamental strains that often trigger more material concerns, we see this as further notice of a correction in a longer secular trend. As Mark Twain said, “I was seldom able to see an opportunity until it had ceased to be one.”

CRN: 2018-0907-6886 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.