Emerging market stocks appear to have gone from front-runner to dark horse in the minds of investors.
Fear of a return to an environment that hobbled emerging markets in the past has gripped the market.
Yet, the current environment may be most similar to those which generated outperformance by emerging markets in the past.
The Belmont Stakes, the third race of the Triple Crown of Thoroughbred Racing, took place this past weekend. The crowd favorite, Justify, became the 13th horse to win the Triple Crown since 1875. As the crowd of 90,327 in Elmont, New York, and many more on television, watched Justify take the lead and win by 1 3/4 lengths, it reminded us of another horse that vied for the Triple Crown 10 years ago: Big Brown.
Kentucky Derby - Big Brown was the winner of the 2008 Kentucky Derby. He was the favorite, living up to high expectations with a stunning win at Churchill Downs by nearly five lengths. He was the first horse since 1929 to win the race from the worst starting position — the 20th gate on the far outside. Remaining undefeated, he became an overnight pop culture phenomenon with a New York Times profile and talk show appearances by his trainer.
Preakness Stakes - Just 10 days after the Kentucky Derby, in his fifth race, the 2008 Preakness Stakes, Big Brown was again the favorite. He won the second leg of the Triple Crown by more than five lengths, becoming only the fourth horse in 133 years to win both the Kentucky Derby and the Preakness while still undefeated. Big Brown, who was from New York, was being hailed as the biggest New York sports star of 2008 by sports writers.
Belmont Stakes - Three weeks later, it was no surprise that Big Brown was again the favorite in the Belmont Stakes. Bookmakers saw record-breaking interest as people who did not usually pay any attention to horse racing were caught up in Big Brown fever. Total wagering at Belmont that year was up nearly 50% over the year before. After all, there was no doubt the undefeated Big Brown would be the winner of the Belmont Stakes and be the first horse to sweep the Triple Crown for the first time in 40 years.
So what happened? Big Brown did not just lose the Belmont—he came in last by a wide margin. In the last turn Big Brown simply—and inexplicably—gave up. Big Brown became the first Triple Crown hopeful ever to finish last in the Belmont. A lot of people lost money that day and tore up their tickets in disgust.
Performance derby: emerging markets
Many investors in emerging market stocks felt like they made a bad bet in the past couple of months and some investors have sold their stakes in disgust. Emerging market stocks, measured by the MSCI Emerging Markets Index, posted a strong gain of 37% last year, encouraging investors to favor the asset class with strong inflows. After a strong start this year, emerging market stocks pulled back with the rest of the global stock market, and then began to underperform the developed stock market beginning in mid-April. The asset class is now down about 10% from its high in January.
But it may be wrong to count emerging market stocks out of the race. Emerging market stock relative performance may depend on the environment: mid-cycle or late-cycle.
Fear has gripped the market of a return to the type of environment that hobbled emerging markets in the past. Those periods included the so-called 1994 Mexican peso crisis, the 1997 Asian Contagion, and the 2013 Taper Tantrum. All three of these periods included the Federal Reserve beginning to take action to tighten monetary policy. Even though these mid-cycle changes in monetary policy did not invert the U.S. Treasury yield curve nor were they followed by a global or U.S. recession, they did boost the broad trade-weighted value of the dollar by about 20% which weighed on emerging market stocks, due to their dependence on dollar-based financing.
During these mid-cycle periods emerging market stocks suffered, underperforming their developed market peers, as you can see in the table below.
Emerging markets crises: change in index during one year following Fed initial action to tighten
Source: Charles Schwab, Bloomberg data as of 6/8/2018.
In summary, during these periods the U.S. stock market outperformed international stocks measured by the MSCI EAFE Index, international small cap stocks measured by the MSCI EAFE Small-cap Index, and emerging market stocks measured by the MSCI Emerging Markets Index. The MSCI Emerging Markets index, specifically, suffered losses on average.
Emerging market stocks had been outperforming developed markets last year and in the first quarter of this year. Investors viewed the current environment as a characteristically late-cycle environment, which have historically been favorable to emerging market stocks. The Fed took initial action to end QE and raise interest rates years ago, flattening the yield curve, and suggesting that this economic cycle is past the mid-point and in the later stages. Within the next couple of years, the Fed’s tightening of monetary policy may become well advanced, possibly contributing to an inversion of the yield curve and a global recession, bringing an end to the economic cycle. During these late-cycle periods, the dollar has historically been relatively stable, balanced between competing forces.
Late-cycle environments have led to outperformance by emerging markets in the past, including the years before the yield curve inverted in 1989, 2000, and 2006. The table below shows how stocks performed one year prior the day that the three month to 10 year U.S. Treasury yield curve inverted in 1973, 1978, 1980, 1989, 2000, 2006, indicating tight monetary policy and signaling a coming global recession.
Emerging markets on top: change in index during one year period before yield curve inverted
Source: Charles Schwab, Bloomberg data as of 6/8/2018.
In summary, during these periods:
- International stocks outperformed during five of the six periods with the MSCI EAFE Index posting an average gain of 21% versus the MSCI USA Index’s 9% return.
- Smaller company international stocks lagged their larger peers as the MSCI EAFE Small-cap Index lagged the MSCI EAFE Index by an average of seven percentage points (although we have only two periods to examine since the international small cap index data begins in 1992).
- Emerging market stocks outperformed with a 27% average return during the three periods (1989, 2000, and 2006) that include emerging markets index data (which begins in 1987). They outperformed despite stress among some perennially vulnerable countries (for example, Argentina defaulted in 2001 and 2014).
As the Fed tightened monetary policy, there was a big difference in the relative performance of emerging market stocks between the mid-cycle and late-cycle environments. As market participants have been rethinking the current environment, emerging market stocks have gone from front-runner to dark horse.
After the stunning rout at the Belmont, Big Brown returned to racing in August 2008 with a win in the $1 million Haskell Invitational Handicap at Monmouth Park, New Jersey. Big Brown’s last race was a month later with another win at the Monmouth Stakes. Big Brown then retired after winning 7 of his 8 career races having earned $3.6 million.
While emerging markets may have lost during the past month or so of the Triple Crown, they may not be ready to be retired from portfolios. Big Brown came back to win again. Emerging market stocks are down -1% for the year so far, but may come back to post gains again this year if investors view the current environment as sharing the most characteristics with the more favorable late-cycle environment.