Tag Archives: MSCI EM

Q3-Market Performance Review

Yesterday was the first day of the Fourth Quarter of 2018, so it’s a good time to assess where markets are for the year. Nobody should change their portfolios radically based on recent market moves, and, to the extent that anybody does, the long term bias should be gently adding what has dropped and trimming what has surged, keeping in mind that catching absolute tops and bottoms is difficult. But, from time to time, it can be useful to observe recent trends.

The first thing to notice about market returns through the first three quarters of 2018 is that U.S. stocks are up again. The S&P 500 Index closed the Third Quarter up 10.58% for the year, including dividends. Mid-cap stocks were up too, though less dramatically. The Russell Midcap Index gained 7.45% for the year through the Third Quarter. Small-cap stocks have gained about as much as the S&P 500, with the Russell 2000 Index up 11.51% for the year. And the Russell Megacap 50 Index also has a similar gain for the year of 11.69%.

Two Discrepancies

If U.S. stocks are having a good year, international stocks aren’t. The MSCI EAFE Index, which tracks stocks from developed countries, lost 1.43% for the year through the end of the Third Quarter. The MSCI Emerging Markets Index (MSCI EM NR) has done ever worse, shedding 7.68% for the year through the end of the quarter. Much of those losses are attributable to the dollar’s surge against foreign currencies, especially those of emerging markets. When U.S investors buy foreign stocks or a foreign stock fund, they typically get two sources of return, the stock’s return in its own market and the foreign currency’s return versus the U.S. dollar. That second return has hurt U.S. investors in foreign stocks this year, as the dollar has surged. A dollar surge also puts emerging markets under a cloud because emerging markets countries and companies borrow in U.S. dollars, making a dollar surge especially burdensome for them.

A second discrepancy is the difference in value and growth stocks. Value stocks tend to trade with lower price-earnings and price/book ratios, while growth stocks tend to trade with higher ratios precisely because of their anticipated growth in earnings and/or book value. The Russell 1000 Value Index rose a tepid 3.92% for the year, while the Russell 1000 Growth Index surged by 17.09%. the top-5 holding of the Russell 1000 Growth Index are Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet (GOOG). The only one of the so-called “FAANG”s that it’s missing is Netflix, and the FAANG stocks have gained more than the overall market.

Bonds and REITs

Bonds, represented by the Bloomberg Barclays U.S. Aggregate Index dropped 1.6% for the year through the end of the Third Quarter. Interest rates have been rising in fits and starts. The yield on the 10-year U.S. Treasury has spiked up above 3% (where it rests now) during the year, but also fallen back at times. Bond yields move in the opposite directions of prices.

Volatility in the bond market has also likely influenced REIT returns. REITs pay out 90% of their net income as dividends in exchange for having tax-free status at the corporate level. The high dividend yield, low-growth companies often trade with some correlation to bonds. REITs (MSCI US REIT Index) tumbled in January and February of this year, the soared in March, May, and June. But in September they shed more than 2% to give them a roughly 2% year-to-date gain. That’s not terrible, but it lags the broader market’s return considerably. Large REIT companies that have declined for the year include paper and forest products company, Weyerhaeuser (WY), office landlord Boston Properties (BXP), and medical space REIT Ventas (VTR).

Judging Your Portfolio

If you have a lot of REIT exposure, that has probably been a drag on your portfolio. That’s why gunning after the highest yielding stocks is sometimes not a good idea. Additionally, if you have a lot of international stock exposure, that’s also been a drag. The discrepancy, for example between the year-to-date returns of the Vanguard Balanced Index Fund (5.6%) and an index consisting of 60% MSCI ACWI (All Country World Index) and 40% U.S. bonds (1.7%) is large.

That doesn’t mean you should exit all your international stock positions. What does badly one year can do better the next. In 2017, for example, international stocks outpaced domestic stocks, and emerging markets stocks, the dogs of this year, gained 37% versus the 22% gain of the S&P 500. Picking a single year’s winners isn’t easy.

Overall, investors should know that domestic stocks are considerably overpriced by any valuation metric one chooses to use. That doesn’t mean they can’t get more expensive, but nobody should be anticipating robust long-term returns from U.S. stocks.

Are Emerging Markets Toast?

Domestic stocks outperformed international stocks for a long time. On a year-to-date basis, the S&P 500 Index was up more than 6% through July, while the MSCI EAFE Index was down slightly and the MSCI EM Index was down more than 4%. The international stock returns are after translation to the dollar, so they assume a U.S .investors bought them without using a currency hedge and received the dual return of the stocks in their local markets and the return of the local currency relative to the U.S. dollar.

In every instance (YTD, 3-, 5-, and 10-year periods), the international stocks performed better in their local markets before translation to the dollar. That means the dollar has been appreciating for a while. It has also been appreciating a lot recently.

There have been years over the past decade when international outperformed domestic. Last year was such a year. The S&P 500 produced a 21.83% return, while the MSCI EAFA delivered a 25.03% return and the MSCI EM Index delivered a whopping 37.28% return. But the recent long term has clearly favored U.S. stocks.

In the past emerging markets were said to be “coupled” with the developed world. If the developed world stopped spending, emerging markets suffered greatly. Also, there was coupling in the sense that emerging markets currencies would plunge when the dollar strengthened, and they’d have to spend all their reserves to prop up their currencies. Emerging markets countries borrowed debt in dollars or other developed world currencies, and dollar appreciation put an extra burden on them.

Has decoupling occurred now? Will the dollar’s rise crush emerging markets again, or have things changed? Are emerging markets able to stand alone now? Nobody knows. Clearly Turkey has been on a borrowing binge that it’s paying for now. But it’s not clear that’s the case with other developing countries.

It’s the dollar, stupid

Still, the FT’s John Authers writes of a “fragile five,” referring to five countries whose currencies are succumbing to a strong dollar — Turkey, India, Indonesia, Brazil, and South Africa. The currencies of these five countries also came under pressure during the “Taper Tantrum” of 2013 when Ben Bernanke talked of tapering his QE purchases.

Authers also notes that the price of gold tells us that the U.S. – or the U.S. dollar – is the cause of the current crisis. Gold has been depreciating; it has “behaved exactly like an emerging market currency, and has endured a true correction, dropping more than 10 per cent from the high it set early in the year.” All currencies depreciating relative to the dollar helps keep inflation in check, but it’s bad for the U.S. trade deficit. It doesn’t encourage American exports.

Authers wonders if the Fed will postpone future rate hikes the way it postponed reducing its bond purchases to temper the anticipation regarding the end of QE. This may indicate if emerging markets turbulence becomes calm.

On the other hand, perhaps Authers is putting too much faith in the Fed’s ability to assuage fears about rate hikes and the dollar. A  recent MarketWatch article noted that emerging markets governments drain their dollar reserves in an effort to bolster their currencies. That means there are potentially “fewer dollars available for interest payments, pushing investors to demand richer yields as compensation for holding riskier debt.” The article reported that dollars custodied by the New York Fed for foreign central banks had decreased by $60 billion to $3.04 trillion in May, off from its peak f $3.11 trillion in March. Given that emerging markets countries borrow in dollars (and other developed market currencies), this could spell more trouble. Time will tell.