Analysts at Columbia Threadneedle observed a linkage between the growth differential between developed and emerging markets and relative performance of these two stock market cohorts. Note in the chart below that, historically, as EM growth increasingly bests that of its more sophisticated counterparts, EM equity likewise tended to outperform. As the chart illustrates, the expectation in coming years is that the disparity will widen, which, if correct, should support EM outperformance for years to come.
The current extreme disparity between Emerging Markets and developed markets relative performance also offers hints that the recent assumption of leadership by EM equities is likely to persist. The next chart illustrates the quarterly performance for the price-only MSCI EM Index versus the price-only S&P 500 Index (in white). The magenta and green series indicate the two standard deviation level, both above and below the current reading, and the gray series represents the average of the last 36 points of the relative performance curve (this system constitutes a modification of the Bollinger Band methodology). Note that reversals following breaches of the two standard deviation threshold tend to mark big picture turning points (a la 1998 and 2008).
The relative performance curve last kissed the lower Bollinger bound at the end of 2015; EM equity has bested domestic stocks by 1,340 bps since (excluding dividends). If history is a guide, investors might reasonably expect the burgeoning trend of EM dominance to persist until relative performance approaches the opposite extreme.
Our team’s own momentum reversal framework likewise suggests EM has embarked on an extended period of outperformance. The third chart again shows the (quarterly, price-only )relative performance of the MSCI EM Index versus the S&P 500 in the upper pane, and the quarterly Coppock Guide (our preferred measure of momentum) below. A classic Coppock Guide BUY signal is triggered when the curve bottoms below zero. This very long-term oscillator bottomed at the end of 2015, and presently appears poised to improve through 2019. We expect superior performance from EM through this timeframe.
Similarly, monthly momentum for EM versus domestic equities (not pictured) troughed in May, and is expected to improve at least into next summer.
In our estimation, the state of the greenback likewise poses a tailwind for Emerging Market equities. Since 1997, the correlation between one-month changes in the MSCI Emerging Markets Index (USD) and the U.S. Dollar Index has been a statistically significant -0.39. Further, rolling correlations have exhibited a consistent downward bias since 2003. This strengthening inverse relationship implies that the depreciation of the dollar has been increasingly positive over time for equities of developing economies.
Last summer our very long-term momentum reversal model (pictured in the bottom pane of the chart below) bottomed for the WisdomTree Emerging Currency Strategy Fund ($CEW), a proxy for EM currencies. This oscillator points to direct support for EM currency appreciation through 2019. We expect the momentum oscillator’s upward movement to coincide with strong EM equity performance over this horizon.
And finally, our annual survey of cyclical capital markets forecasts calls for EM equity to fare better than all other classes of public financial securities over (roughly) the coming five to ten year horizon. Forecasts from AQR, BlackRock, BNY Mellon, Callan Associates, GMO, J.P.Morgan, Research Affiliates and SSGA are unanimous in suggesting that emerging Markets boast better longer-term prospects than all other broad classes of publicly traded equities.
An important note about estimated returns: even if the level of anticipated returns is off, consistency of approach should result in approximately proper ranking. This is to say that if returns from EM stocks fall short of the 8% consensus expectation indicated in the table, we might still reasonably expect better returns from EM over domestic equity, and most other stock market cohorts.
Although empirical analysis is limited, there is evidence that, at least, GMO’s asset class return forecasts add value. For instance, a 2010 study by Edward Tower of Duke University’s Economics Department examined GMO forecasts from 2000 to 2010 and observed a strikingly high correlation between predicted and realized returns, especially for stocks and bonds. This research also found GMO’s ranking of asset classes (from best expected performer to worst) to be quite accurate. A 2013 article in The Economist that considered the firm’s forecasts between 1994 and 2013 came to similar conclusions. The author indicated that “While there was clearly a pessimistic bias to the forecasts, the direction of [GMO’s] guesses was remarkably accurate; the assets they picked to perform best and worst were indeed the thoroughbreds and nags.” Moreover, a 2014 follow up research effort by Berry, Stansky and Tower identified a drop-off in accuracy in more recent years, but still noted a strong correlation of 0.708 between GMO’s average predicted returns between 2000 and 2014, and average actual outcomes.
GMO’s verified track record lends credibility to the other forecasters’ assessment that EM equity is likely to submit higher returns than other segments of the equity space. Further, GMO’s tendency to underestimate returns suggests the consensus expectation for forward EM returns might fall in the right ballpark.