Emerging markets had a really lousy second quarter. This was true for pretty much any index with “emerging” in the name, regardless of whatever other words were there along with it. MSCI Emerging Equities (EM) was down 8%. The JP Morgan EMBI Global Diversified Bond Index (EMBI) hard currency bond index was down 3.5%. The JP Morgan GBI-EM Global Diversified+ local debt index (GBI-EM) was down 10.4%, and the JP Morgan ELMI Plus emerging currency index (ELMI) was down 5.8%. With the S&P 500 up 3.4% for the quarter and MSCI EAFE down a tame 1.2%, it was therefore a pretty tough quarter for our asset allocation portfolios given our large bias toward emerging securities and against US equities.1 Whenever we have a quarter like this we react by looking at what happened, why it happened, and whether it poses a challenge to the assumptions that caused us to have the biases in our portfolios in the first place. In this case our analysis suggests that what has happened is not particularly out of line with other historical events in emerging markets. The event shows starkly the distinction between emerging and developed markets and is a demonstration of why we consider emerging markets to be riskier than other assets that we invest in. Momentum has historically mattered in emerging markets, so there is some reason to expect that there may be more pain to come in the short term. However, nothing that has happened in the markets or to the underlying fundamentals causes us to doubt our longer-term thesis that emerging markets are the best investment opportunity available today by a substantial margin.
So what happened last quarter, and why were emerging markets hit so hard? Simply put, it was a very strong quarter for the US dollar (USD), with the DXY dollar index up 5%.2 That is a 1.1 standard deviation event, which makes it a little out of the ordinary, but not a true outlier. It probably comes as no surprise that when the USD rises, the US stock market outperforms non-US markets. But what makes emerging markets unique is the fact that this doesn’t simply occur due to the currency translation effect. This quarter, for example, the currency basket of MSCI Emerging fell by 4.8%, precisely the same as the fall for the currency basket of MSCI EAFE. In other words, while some specific emerging currencies fell a lot in the quarter – the Turkish lira fell 13.4% and the Brazilian real fell 10%, for example – you’d be hard-pressed to call this a general case of emerging currency weakness so much as USD strength. But while MSCI EAFE rose 3.5% in local currency terms, slightly outpacing the rise in the S&P 500, MSCI Emerging fell 3.5% in local currency terms. This is par for the course. It is only a mild overstatement to say that the basic difference between the developed world and the emerging world is that when a developed world country has a declining currency, all else equal that is good for that country’s stock market, whereas when an emerging country has a declining currency, all else equal that is bad for that country’s stock market.
This is true over and above the fact that emerging market currencies tend to have a positive beta – that is they tend to rise when global stock markets are rising, and fall when stock markets are falling. Some developed market currencies, like the Australian dollar, also show a positive beta, although other “safe haven” currencies like the Japanese yen and Swiss franc tend to do well when global stock markets are falling. Exhibit 1 shows the correlation between currency and local stock market movements for 35 developed and emerging markets after we remove the effect of co-movement with the S&P 500.
Two-thirds of developed currencies have a negative correlation with their local stock markets, and the figure for EAFE as a whole is -0.2, whereas every single emerging market of those listed above has a positive correlation, and the figure for MSCI Emerging is 0.6. This correlation is arguably the reason why emerging markets are more volatile than developed markets in the first place, as we can see in Exhibit 2.
In local terms, MSCI emerging has been almost exactly as volatile as the US or EAFE markets since the end of 2009, but due to the strong positive correlation between the local returns and the return to emerging market currencies, the volatility in US dollars is significantly higher than for the S&P 500 or EAFE.
This is an excerpt from Ben Inker's Q2 2018 Quarterly letter for GMO. You can read the complete version here.
The writer is the head of GMO Asset Allocation and a board member of GMO.