05-07-2014 01:29 PM
By Wasif Latif, head of global multi-assets
The escalating dispute over Ukraine’s sovereign borders is generating global headlines and worrisome what-ifs, but so far the economic ramifications have been largely local. The broader story for emerging markets investors in 2014 is the same as it’s always been: China.
The MSCI Emerging Markets Index is essentially flat so far this year, but the ride has been a wild one. The index tumbled more than 8% in the first few weeks of the year due to liquidity concerns as the Federal Reserve began tapering its quantitative easing program. But since early February, the index has regained all of that decline, even as the Fed has steadily tapered QE from $85 billion per month in December to $45 billion in May.
China, which accounts for nearly a fifth of the MSCI EM index, opened the year with a 10% fall, and since then it has followed an M-shaped course of peaks and valleys. In 2014, it is down more than 8%. Making up for China’s decline has been Brazil (+8.2% YTD), India (+7.1%), South Africa (+4.1%) and Taiwan (+3.8%).
China’s slowest GDP growth pace in many years is almost certainly weighing on stocks, as have wage and commodity costs that exert a negative impact on earnings. The flip side is that the underperformance in China has made valuations very attractive. When stocks are cheap and expectations are low, an upside opportunity is created. There comes a day when the bad news is not that bad, and when that happens, you see a re-rating of assets, and then those assets are positioned to start outperforming.
We saw this scenario play out last year in developed Europe after its banking crisis, and we’re seeing it now in the so-called “Fragile Five” emerging market countries (Brazil, India, Turkey, South Africa and Indonesia) that were battered early in 2014 over currency worries but have since bounced back. This recovery path doesn’t mean that volatility goes away, but once the data stabilizes, valuations can take on more prominence.
The situation is different right now in eastern Europe, though in the end, we could also be looking at a valuation story.
Russia, which took over Crimea and is now seen as driving a separatist movement in eastern Ukraine, has watched its currency and its stock market drop sharply in 2014. In Ukraine itself, the currency has plunged more than 30%, and bond yields are soaring as worries of civil war grow by the day. But in neighboring markets in eastern Europe, the impact is hard to see in the numbers.
There is room for the West to expand its sanctions against Russia, but because the impact of sanctions are slow to develop, they would likely take some time to be felt in the overall economy. And while Europe may oppose Russia’s role in Ukraine, it may be reticent to push too hard for harsh punishment lest it hurt itself in the process. Europe’s economy, still working to pick up growth traction, relies heavily on Russia as a source of energy and as a large and reliable market for its export sector.
From an investment perspective, history will tell you that geopolitical events can create short-term market noise and longer-term buying opportunities. Will this be the case with Russia? That’s hard to know at this point, but we are paying close attention to what’s happening in Ukraine. Given the 20% drop in stocks so far this year, it appears that the Russian market is cheap and that it could be getting even cheaper.
As long-term value investors, this is something that we can’t simply ignore. We are going through our processes, and as with any investment opportunity, we will sort through important macro factors and company-specific measures. This helps us determine if there’s a risk-reward rationale in which we and our shareholders would be appropriately compensated for any risks taken.
USAA Investments Managed Portfolio Outlook
Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are stretched and profit margins are near record highs.
We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.
We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.
We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.
This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.
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