By Ivan Martchev
The MSCI Emerging Markets Index, the benchmark for investors interested in emerging markets, has been underperforming the S&P 500 for three years. I am sorry to say emerging markets seem destined to continue underperforming in 2014 in part due to the pending unwind of QE and its repercussions.
I stared at the relative chart of the iShares MSCI Emerging Markets Index fund /zigman2/quotes/201454250/composite EEM +0.67% (when divided by the SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY -0.18% ) almost with disbelief. On a relative basis, things are as bad for emerging-market investors as they were five years go near the infamous low in global markets in March 2009. EEM has rallied off that low, but the S&P 500 has rallied so much more that it is easy to see how investors interested in global markets can get disheartened.
As a matter of strategy, I believe that over the long term, EEM should outperform most similar to SPY developed-market investments, as emerging markets have better demographics and their economies grow faster from smaller bases. In most cases, emerging economies develop based on savings and investment economic cycles that are lacking in most of the developed world, save for Germany.
The U.S., and most of developed Europe for that matter, are growing based on a spending-and-borrowing spree prolonged by gigantic monetarist maneuvers like QE. The former type of economic growth is building a foundation for a prosperous future, while the latter is borrowing from the future to sustain a consumption pattern that present developed-world income generation cannot afford.
By now it should be clear that I am a firm believer in the long-term fundamentals of emerging markets, yet I think they will have serious issues in 2014. The "long term" is about strategy and fundamentals, but how we get there is about tactics. Tactically speaking, the pain in emerging markets is not over.
The EEM ETF also reflects the performance of local currencies. Most emerging-market currencies have been under serious pressure in 2013 particularly because of the pending QE tapering. The Brazilian real, Russian ruble and Indian rupee started 2013 at 2.05, 30.52 and 54.99. At last count, the three BRIC currencies in the same order are quoted at 2.34, 32.79 and 61.83. The Chinese yuan is different, as it is not free-floating and has appreciated from 6.23 to 6.07 as per PBOC policy. Smaller emerging-market currencies like the South African rand have been hit even harder over the same period falling from 8.47 to 10.42 at last count.
This emerging markets' currency weakness that is affecting U.S.-dollar-based investors is multidimensional. There is weakness in commodity prices due to subpar global growth at the moment. There is also the potential for a much bigger dollar rally, further likely to suppress commodity prices, as real U.S. interest rates are rising with the attempt to reduce QE. This has affected emerging economies dependent on commodities negatively and has hit their currencies notably.
A lot of dollars have been borrowed to build commodity producing capacity, and this dollar indebtedness is acting like as stone around the necks of some emerging-market governments as well as corporate borrowers. A direct way to gain exposure to commodity space has been DB PowerShares Commodity Index fund /zigman2/quotes/205569319/composite DBC +0.83% . This ETF needs to be monitored for signals from the commodity markets, as I expect this index to weaken further in a QE tapering environment compounded by subpar global economic growth.
While there is an attempt to taper QE in the U.S., in Japan the BOJ is looking for creative ways to weaker the yen and generate higher inflation. Yen weakness is negative for emerging markets, as it undermines their competitiveness directly, particularly those in Asia. Some major contributors that preceded the 1998 Asian Crisis were a rally in the dollar and a massive selloff in the yen. We have the potential for both to keep happening in 2014.
What should one buy in such a QE-tapering environment? Buying and holding dollar assets may be the answer, even though this may be a better relative trade than an absolute one. This is because both dollar assets and emerging-market assets may see downward repricing in a QE tapering, but assets denominated in dollars are going to feel the currency tailwind, while assets denominated in emerging-market currencies may see further local currency weakness compounding their decline.
I don't see an easy buy-and-hold strategy to benefit from any of this, other than to say that I expect a lot more volatility in 2014 than in 2013 — great for aggressive traders — if the rumored QE tapering happens on schedule and the dollar appreciates because of it. Should this occur, the EEM/SPY pair is likely headed lower.
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates does not hold positions in any securities mentioned for its clients. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.