03-07-2014 10:27 AM
By Wasif Latif,
Vice President, Equity Investments
The tensions in Ukraine ratcheted up a notch or two late this week when leaders of the nation’s Russian-occupied Crimea region said they will hold a vote in 10 days on unilaterally seceding from Ukraine and becoming part of Russia. Given that ethnic Russians are an overwhelming majority of Crimea’s population, we don’t expect the outcome of that referendum to be a real nail-biter.
Meanwhile, back in the U.S., the White House continues to threaten Moscow with sanctions and the Standard & Poor’s 500 index continues to set new records. The large-cap stock index has finished the trading day at all-time highs four times since the crisis in Ukraine ramped up in late February. The S&P 500 is up nearly 6% in the past month despite little positive news at home and the rising possibility of military action on the European Union’s eastern doorstep.
Geopolitical situations of this potential magnitude typically weigh heavily on global markets, with nervous investors moving quickly to get risk off the table. With the exception of Russia, where both the stock market and the ruble have seen a double-digit decline this year, however, this has not been the case. So what’s different this time around?
We think a big part of the explanation is that the Ukraine situation is developing slowly, so there’s no pressing need for market participants to act. By comparison, January’s currency troubles in Turkey and several other emerging nations sent an immediate shock through the system and thus triggered a rush for the exit.
Investors are certainly concerned about the hardship on the ground in Ukraine and how the major energy pipelines that connect Russia to Western Europe may be affected. But as long as there’s no feeling that an escalation into a wider conflict is imminent, the markets may remain calm. In other words, the markets seem to be giving diplomacy the benefit of the doubt. Of course, volatility could suddenly flare up if it appears that the standoff in Ukraine may not have a near-term political solution.
From a timing standpoint, following closely on the heels of the January currency panic, events in Ukraine might have played into a broader narrative that emerging markets carry too much political risk. By that line of thinking, investors would be better off to focus on developed markets that are safer and more predictable, with stronger corporate governance and less governmental involvement in picking the economic winners and losers.
But the market response to Ukraine is further evidence that, from a risk perspective, emerging nations are no longer lumped together as a group. As they have grown in size, these countries have become more diversified in their economic drivers. Their business cycles and policies have not evolved in a lockstep fashion, and as a result, investors have to take a more granular approach in choosing where they put money to work.
The current underperformance that we are seeing in key emerging-market countries is based on rational economic factors — softer corporate earnings and margins, rising inflation and wages, and the reduced liquidity due to tapering by the Federal Reserve. In this sense, emerging markets are being increasingly judged by the same standards used to value developed markets.
Despite the current subdued conditions, the longer term appeal of select emerging markets remains intact. They are growing faster than the developed world, have less sovereign debt, and have an expanding consumer class. At today’s prices, we believe they are less expensive from a valuation perspective, especially when measured against the U.S., where earnings and valuations appear stretched.
Sure, emerging markets can get even cheaper, but we are comfortable with our overweight position. We’re looking past the near-term weakness and instead at the greater upside potential that these countries present over the long term.
Regarding Friday’s U.S. unemployment report, the numbers came in stronger than expected, which initially lifted markets. But then the longer-term ramifications were taken into account, which led to a selloff. Signs of economic improvement will hasten an end to the Fed’s quantitative easing (QE3) program, which will speed up the arrival of higher interest rates. Over the short term, markets are more sensitive to the negative impacts of rising interest rates than they are to the benefits of economic growth.
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. We are also tactically underweight fixed income. We remain slightly overweight cash in our diversified managed portfolios.
We also are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund also provides potential protection against the risks of long-term inflation.
Emerging markets represent another opportunity. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. They offer both an interesting long-term prospect for growth and compelling valuations. 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 you based upon 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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Past performance is no guarantee of future results.
Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.
The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.
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High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.
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