Friday, January 15th, 2021
“Emerging Markets: A Good Diversifier for an Uncertain Future?”
As we all know, 2020 was quite a year for the markets. Despite a Pandemic, lockdowns, and numerous other disruptions throughout the year, financial markets proved incredibly resilient - recovering at record speed from the March 23rd lows. However, the run-up in US equities has led to valuations that are well above historical averages - investors should recognize that higher valuations are often a headwind to future returns.
This is not to say that US equity markets don't have legs to continue their march upward, as the US economy has certainly proven its ability to be resilient and surprise on the upside over time.
However, US equities face plenty of challenges in 2021 and beyond. To name only a few: civil unrest; seemingly continuous, unprecedented Federal stimulus creating higher deficits/debt burden, thus leading to weakness in the US dollar (USD); supply chain disruptions and the peaking of globalization potentially creating higher cost of goods and labor; etc. are all sizeable headwinds.
Given the high level of uncertainty over the next few years for US equity markets, investors should look for the best ways to diversify. We believe one of the best ways to do this is to increase exposure to Emerging Market (EM) equities.
Why? For one, the ideal diversification tool is something that contrasts with what you already own. Since most US portfolios are heavily invested in dollar-denominated assets, EM equities serve as a great counterweight as they are negatively correlated with the USD.
An asset being a good diversifier is often a good enough reason alone to make a portfolio allocation, but it's even better when there are numerous catalysts for that asset to outperform going forward, which EM has:
- An essential catalyst for EM to outperform US equities is a falling USD. The USD has been declining since the initial massive liquidity and stimulus injections, and EM equities have outperformed in that time frame. Going forward, there seems to be no end in sight for this type of dollar debasing behavior.
- After suffering a decade of underperformance, the valuation gap between the US/EM is the widest it’s been in almost 20 years. EM equities throughout history have generally mean reverted against US equities, this means you can diversify your portfolio with a potentially outperforming asset class, without having to pay a high valuation.
- The recovery in EM equities that began in late Q1'2020 picked up steam in Q4'2020 thanks to the CV-19 vaccine breakthroughs. They should continue to benefit as the vaccine is distributed across the globe.
- Earnings have risen sharply in recent months, and expectations for 2021 are soaring as well due to vaccine's normalizing the economy.
- In their latest forecast, the International Monetary Fund projected 6% growth for EM’s and 3% for developed markets in 2021, with the growth gap only widening after that.
- There are plenty of other long-term drivers of EM economy outperformance going forward: technological leapfrogging, faster productivity growth, better demographics, and a rising labor market participation.
Though these are all very promising catalysts, EM outperformance is far from certain, but we believe an allocation still seems prudent. The global economy seems to have been radically changed by this Pandemic and going forward it may further change in ways that are hard to imagine at the present moment. Given this uncertainty, it makes all the more sense to spread your bets.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. There is also no assurance that any investment strategy will assure success or protect against loss.