ETF investors have allocated to emerging market ETFs for sixteen consecutive months but have not been rewarded. While the case for emerging markets looks somewhat conducive from a valuation perspective, weak price momentum and an uptick in volatility in the region continue to make emerging markets a risky option.
Over the past sixteen months, emerging market (EM) ETFs have taken in $44 billion, recording inflows in every month. If they post inflows in February, that would tie their record for consecutive monthly inflows (17) set in 2016-2018. Back then, EM stocks outperformed developed by 13.40%.1 This time, EM has underperformed by 16.5%.2
Sluggish performance aside, consistent flows into EM exposures has led clients to ask a) What am I missing? b) Does overweighting EM make sense in our current market?
In this Charting the Market, I address those questions using a value, sentiment, and momentum screening process – alongside a top-down macro view. And the data doesn’t paint the “pound the table” buying opportunity that the inflows indicate.
Clients who have stayed away from emerging markets have not missed much given the weak performance. Yet, while flows have not been rewarded so far, what if investors are positioning for what’s to come? Could EM be about to go on a multi-year period of outperformance? To answer this question, I analyzed valuation, sentiment, and momentum metrics.
For valuation, I compared four current fundamental ratios relative to their own history over the past 15 years. As shown below, all four metrics plot above the median, with the current Price-to-Sales ratio in the top quintile. So, relative to its own past, EM is, to a degree, trading fair-to-rich and not cheap.
The case for EM from a value perspective, however, strengthens when compared to the S&P 500 Index. On a relative screen, each of those four metrics plots below the bottom 5th percentile, historically.
So, relative to the US, EM is cheap and does present a value opportunity. Yet, as shown in the chart below, most major markets are cheap when compared to the richly valued US. And when ranked against other major markets and styles, the “cheapness” of EM is not as unique —or the most attractive.
The valuation case for EM is cheap for a reason. Unlike in the other “cheap” markets (US small caps and developed-international markets), EM earnings sentiment is weak.
As shown below, the ratio of analyst upgrades-to-downgrades for 2022 Earnings-per-Share (EPS) growth has been below one (meaning more downgrades) for the past two months. Out of the four markets, EM is the only segment with a ratio below one. It also has had the lowest ratio every month for the past 11 months. It’s quite clear earnings sentiment is weak in the region – perhaps why relative valuations are so low.
With such weak sentiment, EPS growth is also below other markets. Overall, 2022 EPS growth is expected to be just 5% for EM, declining by two percentage points (from 7% to 5%) since the end of Q3 2021. Both US large- and small-cap stocks have witnessed upside revisions while EAFE’s estimates fell only by a few basis points (from 5.82% to 5.7%), as shown below.
Weak sentiment has translated into weak overall growth, limiting any attractiveness from the value case presented above (i.e., value trap). Conversely, as we outlined in our 2022 outlook, the inexpensive valuations combined with elevated growth estimates make small caps a potentially worthy allocation for those seeking a “value” play.
Weak returns weak and poor fundamental sentiment make momentum metrics unattractive for EM. Across nine different screens for momentum, time-series, cross-over, and continuous (i.e., frog-in-pan),3 emerging markets rank as the eighth- or ninth-worst market in seven of the nine categories.
Within emerging markets, inflation is expected to be 4.3% for full year 2022.4 Based on the Citi Emerging Economies Inflation Surprise Index, inflation reports have been significantly surprising to the upside. The surprise index now sits in the top 95th percentile over the past five years,5 an indication that the consensus estimate may be revised higher if that trend continues.
With inflation elevated, central banks in the region are hiking rates, as shown below. The average central bank rate for EM economies has been increasing over the past few months, reversing a downward trend from prior years.
In fact, 45% of EM central banks have hiked rates over the past three months.6 On a relative basis, seven EM banks have hiked compared to just one for developed nations over this time period, indicating EM is a bit ahead of developed markets in terms of normalizing policy.7
These actions will reduce liquidity and likely lead to higher volatility. The latter is already on display given the recent sell-off that had levels of implied volatility hovering around the 90th historical percentile for a few days to start the month.8 Potential conflict between Ukraine and Russia and tension between the US and China with respect to trade and technology add to the macro risks.
From an economic perspective, the Markit Emerging Markets Composite PMI fell to a neutral 50 reading and regional forecasts for GDP have been guided lower.9 Lower growth, high inflation, high political risk, and higher rates do not support a conducive macro backdrop.
Of the four variables considered, only valuations currently support a tactical overweight to EM. Yet EM stocks do not screen the cheapest of major markets. Also, when broadening the scope of this analysis, we see that EM stocks are likely cheap for a reason (weak sentiment, low growth) and should command a higher premium for investors to take on the risks associated with the region.
But not all emerging markets are subpar right now. Factor returns in the region; high quality, inexpensive, and lower volatility stocks have all outperformed the broader EM market over the past three, six, and 12 months, as shown below.
Overall, it’s difficult to make a strong case that EM equities warrant an overweight in today’s portfolios.
Yet given the backdrop of weak earnings sentiment and elevated volatility, a sensible way to allocate to EM right now might be to focus on the factors that have worked: inexpensive stocks (thereby improving the slight valuation case) with more quality growth profiles and lesser systematic risk.
For more market insights, check back to SPDR Blog and read our monthly chart pack where we feature valuation, sentiment, and momentum scorecards each month. For information on factor investing, check out our Smart Beta page.
1Bloomberg Finance, L.P. as of February 7, 2022 based on returns for the MSCI Emerging Market Index and MSCI World Index from 11/30/2016 to 04/30/2018.
2Bloomberg Finance, L.P. as of February 7, 2022 based on returns for the MSCI Emerging Market Index and MSCI World Index from 10/30/2020 to 02/07/2022.
3Frog in the Pan: Continuous Information and Momentum, Zhi DaUmit G. GurunMitch Warachka
4Bloomberg Finance, L.P. as of February 7 2022 .
5Bloomberg Finance, L.P. as of February 7 2022.
6Bloomberg Finance, L.P. as of February 7 2022.
7Bloomberg Finance, L.P. as of February 7 2022.
8Bloomberg Finance, L.P. as of February 7 2022 based on three-month 100% moneyness options on emerging market ETFs.
9Bloomberg Finance, L.P. as of February 7 2022.
Euro STOXX 50 Index
Europe’s leading blue-chip index for the Eurozone, provides a blue-chip representation of super-sector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries.
Minimum Volatility Factor
A category of stocks that are characterized by relatively less movement in share price than many other equities.
MSCI EAFE Index
An equities benchmark that captures large- and mid-cap representation across developed market countries around the world, excluding the US and Canada.
MSCI Emerging Markets Index
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI EM Enhanced Value Weighted Index
The MSCI EM Enhanced Value Weighted Index captures large and mid-cap representation across the EM equity markets exhibiting overall value style characteristics. The index is designed to represent the performance of securities that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector.
MSCI EM Minimum Volatility Index
The MSCI EM Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid cap equity universe. The index is calculated by optimizing the MSCI EM Index, its parent index, for the lowest absolute risk (within a given set of constraints). Historically, the index has shown lower beta and volatility characteristics relative to the MSCI World Index.
MSCI Europe Index
The MSCI Europe Index is a free-float weighted equity index designed to measure the equity market performance of the developed markets in Europe.
MSCI Japan Index
The MSCI Japan Index is a free-float weighted equity index designed to measure the equity market performance of the developed markets in Japan.
MSCI World Index
The MSCI World Index is a free-float weighted equity index that includes developed world markets, but does not include emerging markets.
S&P 400 Index
The S&P MidCap 400® provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500®, is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.
S&P 500 Index
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
S&P 500 Value and Growth Index
The S&P 500 Value Index is a market capitalization weighted index. All the stocks in the underlying parent index are allocated into value or growth. Stocks that do not have pure value or pure growth characteristics have their market caps distributed between the value & growth indices.
S&P 600 Index
The S&P Small Cap 600® provides investors with a benchmark for small-sized companies. The index, which is distinct from the large-cap S&P 500®, is designed to measure the performance of 600 small-sized companies, reflecting the distinctive risk and return characteristics of this market segment.
One of the six widely recognized, research-based smart beta factors that refers to “quality” equities. Companies whose stocks qualify exhibit consistent profitability, stability of earnings, low financial leverage and other characteristics consistent with long-term reliability such as ethical corporate governance.
One of the basic elements of “style”-focused investing that focuses on companies that may be priced below intrinsic value. The most commonly used methodology to assess value is by examining price-to-book (P/B) ratios, which compare a company’s total market value with its assessed book value.
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