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Emerging markets are so far among the strongest stock plays of 2017, easily outperforming other regions and assets, and bulls are betting the upward momentum will continue. The region has long been an underperformer relative to U.S. markets—it continues to trade under its pre-financial crisis peak, whereas Wall Street has set dozens of records over recent years—but emerging market stocks have outperformed in 2017. The Vanguard FTSE Emerging Markets ETF VWO, +0.11% is up 23.3% thus far this year, more than twice the 9.2% rise of the S&P 500 SPX, +0.46% The iShares MSCI Emerging Markets ETF EEM, +0.16% is up more than 27% in the year to date, while the iShares Core MSCI Emerging Markets ETF IEMG, +0.22% is up 26.7%.
The divergence between the two emerging-market ETFs comes because they track different indexes with different components and constructions. The noncore iShares fund, for example, counts Alibaba Group Holding Ltd BABA, +2.29% as one of its largest components; the stock is up more than 90% thus far this year and isn’t a component of the FTSE index that Vanguard’s fund tracks.
While the two funds have performed differently, the overall trend in the region has been positive, and the gains have taken it above what LPL Financial described as a “10-year bearish trendline.” Ryan Detrick, the firm’s senior market strategist, said that was “yet another sign that the EM strength is real and could continue.”
Detrick didn’t indicate what kind of upside potential was likely following the breakout he described, but he also noted that the region looked strong on a relative basis. “After lagging for many years, there has been a significant breakout to two-year highs in the MSCI Emerging Markets Index relative to the S&P 500,” he wrote in a note, calling this “another indicator that the EM strength could be legitimate and should continue to be a place to find potential alpha in well-diversified portfolios.”
Alpha refers to outperformance relative to traditional benchmarks like the S&P 500 or the Russell 2000.
While technical factors can dictate market direction in the short term, longer moves are predicated on fundamentals, something that Detrick also said supported emerging markets, a region that is typically seen as riskier and more volatile, while offering the potential for higher growth. “What makes the recent strength in emerging markets encouraging is that we’ve also seen a big pickup in corporate earnings, and valuations are still modest relative to the rest of the world,” he said.
In a sign of how emerging markets have led among non-U.S. stock categories, the ETFs have also outperformed the broader Vanguard FTSE All-World ex-US ETFVEU, -0.19% which looks at all global stocks, excluding the U.S. That fund is up 17% in 2017.
The strength in the region comes at a time when U.S. valuations are stretched, according to many metrics. By one calculation, the U.S. is the most expensive market in the world. In that environment, investors and analysts have increasingly looked to overseas markets for upside potential.
Based on the components of the EEM iShares fund, emerging market stocks have a price-to-earnings ratio of 25.12, along with sales growth of 6.55% and a dividend yield of 2%. The S&P has the same dividend yield and modestly higher sales growth—6.87%—but it trades at a much more expensive valuation, with a P/E of 30.8. Investors have been moving into emerging market funds this year. Vanguard’s ETF has had $6.8 billion in year-to-date inflows, while $2.4 billion has moved into the iShares fund, according to FactSet. The core iShares fund has had nearly $12.5 billion in inflows, the fourth highest of any equity ETF.
According to Hedge Fund Research, investors allocated new capital to EM hedge funds for the first time since the second quarter of 2015 in the second quarter of this year. EM funds had $800 million in net new inflows, while overall EM capital increased by $7.5 billion in the quarter. Total EM hedge fund capital grew to $213.3 billion, the fourth consecutive quarterly record.
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Global markets have done great so far in 2017. Are the gains sustainable?
With attractive returns such as haven't been seen for quite a few years, investors in global stock markets have had a very good first half of 2017. Record levels for several widely-followed country indexes occurred in the context of notably muted volatility, adding to the sense of investor comfort and accomplishment. All of this was accompanied by tensions and transitions -- some completed and others frustrated, at least for now -- that will likely influence how investors feel at the end of the year.
Here are six key things you should know about recent developments, along with some important determinants of prospects for the remainder of the year:
A generalized global stock market rally: According to a Wall Street Journal analysis of the world’s 30 biggest stock markets by value, 26 registered gains in the first half of 2017 (the exceptions were Canada, China, Israel and Russia). At the global level, this delivered the best first-half performance since the immediate bounce back from the depth of the 2008-09 global financial crisis. Almost half of these 30 markets ended June at or near record highs.
Market leadership rotated with relatively diversified sector performance: Within the S&P, the largest market in the world, nine of 11 sectors delivered gains to investors. Yet dispersion was notable, both overall and within certain segments -- notwithstanding a further shift to passive investing and the proliferation of index-based exchange-traded funds. Tech and health care led, with returns of 17 percent each; telecom lost 13 percent and energy 14 percent. Amazon surged while many traditional brick-and-mortar retailers languished. Despite a late gain that helped markets overall offset a June slump in tech, financials ended the six-month period only slightly above water. Meanwhile, size also mattered. The Dow and S&P gained 8 percent, along with 14 percent for the Nasdaq, while the Russell small cap benchmark lost about 5 percent.
Market drivers changed but the critical sustainability handoff remained elusive: Starting the year, markets were heavily influenced by hopes of a policy surge in the U.S. that would boost economic growth and corporate earnings in a sustainable and consequential fashion. But the political decision to try to push health care reform through Congress first put both tax reform and infrastructure in the back seat for now. As such, the surge in “soft data,” including in measures of corporate and household confidence, did not pull up more of the “hard data,” which remained sluggish. The potentially adverse impact on markets of delays in pro-growth policy implementation was offset by two other factors: Data pointing to a correlated global reflation (which, with time, seems to be proving more transitory); and continued injection of liquidity.
Forget economic and policy fundamentals, liquidity ruled: Liquidity injection was -- once again -- what mattered most for traders and investors in the first half of the year, offsetting not just economic and policy headwinds, but also geopolitical, institutional and political ones, too. And this ample liquidity came from three sources. First, record corporate profit levels, which translated into continued stock buybacks and higher dividend payments by companies, including dramatic announcements by banks last week after a green light from their regulator. Second, elevated inequality levels that continued to result in a significant portion of the incremental income generated in the economy accruing to wealthy households with a higher propensity to invest in financial markets. Third, the continuation of ultra-simulative central bank policies, including sizeable monthly asset purchases by the Bank of Japan and the European Central Bank.
Other markets signals suggest less confidence about economic fundamentals: Having traded in a range of almost 60 basis points during the first half of the year, yields on 10-year Treasuries ended at 2.30 percent, somewhat below their starting level of 2.44 percent. In the process, the yield differential versus German Bunds narrowed noticeably. Even more significant was the considerable flattening of the yield curve, usually an indicator of an upcoming economic slowdown. Meanwhile, the dollar gave up all, and more, of its post-election surge; and oil prices ended down around 14 percent as concerns over supply were hardly dented by any demand optimism.
And throughout all of this, the contrast between two key features of a liquidity rally intensified: Given the importance of liquidity -- in determining not just returns but also in repressing volatility and in changing fundamentals-driven asset class correlations -- markets ended the period in the midst of an intensified tug of war between crowded trades and “buy on dips” investor conditioning.
All of which sets up markets for an interesting remainder of the year, in which traders and investors will need to keep a close eye on:
The continued impact of liquidity, especially given that several systemically-important central banks (including the Bank of England, the ECB and the Federal Reserve) are likely to be navigating a careful reduction in their stimulus policies.
Progress in the handoff from liquidity to more sustainable validators of asset prices, particularly pro-growth policies in the U.S. and Europe.
The extent to which the spread to liquidity-inconsistent market segments of pooling vehicles, including high-yield and emerging-market ETFs, has overpromised readily available liquidity to traders and investors, thereby risking bouts of unsettling contagion.
Spain's biggest bank Santander is to buy struggling rival Banco Popular for a nominal one euro after European authorities determined the lender was on the verge of insolvency.
Santander will ask investors for around 7 billion euros ($7.9 billion) of fresh capital to cover the cost of bolstering Popular, which has been weighed down by billions of euros of risky property loans.
The rescue, which followed a declaration by the European Central Bank that Banco Popular was set to be wound down, marks the first use of an EU regime to deal with failing banks adopted after the financial crisis.
It breaks the mould of using taxpayers' money, instead imposing steep losses on shareholders and some creditors of the bank, a step two debt investors described as unexpected.
The owners of so-called AT1 and AT2 bonds suffered roughly 2 billion euros of losses, while shareholders lost everything. Senior bondholders were spared.
While concerns about the global economy continue to plague investors, Paris-based OECD has forecast that the global economy is on course for its fastest growth in close to six years but has warned that countries need to strive to do better.
The Organization for Economic Co-operation and Development has predicted that the global economy is set to grow 3.5 percent in 2017, followed by an increase to 3.6 percent in 2018 as confidence is increasing and investment and trade are picking up from low levels. "International trade growth revived in the last year, although it still remains less robust than in pre-crisis decades. Technology-driven and deeper trade integration through global value chains creates new markets and raises productivity," the OECD said in the official forecasts. However, the OECD Secretary General, in an interview with Reuters, said the global economy needs to do more. "Everything is relative. What I would not like us to do is celebrate the fact that we're moving from very bad to mediocre," Angel Gurria told Reuters, adding that this doesn't mean the world has to get used to it or live with it but have to continue to strive to do better.
U.S. downgraded: Although the OECD upped its forecasts for global growth for 2017, it downgraded its estimates for the United States, despite a weaker dollar boosting exports and tax cuts supporting household business investment. The growth forecast for U.S. was downgraded to 2.1 percent this year and 2.4 percent next year, down from estimates in March of 2.4 percent and 2.8 percent, respectively. Catherine Mann, chief economist at OECD, attributed this drop in forecast for U.S. economic growth to delays in President Trump's plans to push ahead with planned cuts and infrastructure spending.
For years, U.S. stocks have been a primary driver of global equity market gains, posting far stronger results than the rest of the world. That may be about to change.
A number of market participants are urging investors to look abroad for their stock exposure, expecting overseas markets to post stronger returns than the U.S., a region they see with limited upside given stretched valuations and tepid economic growth.
Such a change in regional dominance would represent a fundamental shift from the past decade. Since the end of April 2007, the Vanguard Total Stock Market ETF VTI, -0.11% has surged 67.3%; the Vanguard FTSE All-World ex-US ETF VEU, +0.10% is down 9.7% over that same period.
“This secular cycle of U.S. outperformance is coming to an end,” wrote Vincent Deluard, vice president of global macro strategy at the broker-dealer division of INTL FCStone Financial Inc.
“First, valuations price in an absurd growth differential in favor of U.S. assets. Second, a wave of economic data signals that U.S. growth has been overestimated, while Europe and emerging markets are surprising to the upside. Third, historical precedents suggest that U.S. assets fare very poorly in periods of reflation, bitter partisanship and large deficits.”
Deluard added that the U.S. would need to outgrow Germany by 1.9% annually to justify the current gap in valuation.
In the first quarter, U.S. gross domestic product expanded at an anemic 0.7% annual pace, the weakest growth in three years. Some of that was attributed to seasonal and temporary issues; the International Monetary Fund expects the U.S. to grow 2.3% for the year. Such a growth rate would lag behind the rest of the globe, which is seen expanding at a 3.5% pace this year.
Concerns about growth come at a time when U.S. stock prices are seen as elevated. By one metric, they are at their priciest since 2004. The components of the Vanguard Total Stock Market ETF, which looks at the entirety of the U.S. stock market, have an average price-to-sales ratio of 30.44, among the highest of any region.
To compare to other areas, the components of the ex-U.S. fund have a P/E ratio of 26.66, while the ratio is 22.16 for the Vanguard FTSE Emerging Markets ETF VWO, +1.61% For the Vanguard FTSE Europe ETF VGK, -0.04% which measures all of Europe, the P/E is 28.32.
Other metrics of valuation also appear elevated in the U.S. relative to other markets, and investors have noticed.
“The valuation of emerging markets is half the valuation of the S&P 500 when you look at things like price to sales, price to book,” said Jeff Gundlach, founder of DoubleLine Capital, in an interview with CNBC following his presentation at the Sohn Investment Conference on Monday.
Gundlach recommended a pair trade, shorting an S&P 500-tracking exchange-traded fund SPY, -0.15% while simultaneously buying the iShares MSCI Emerging Markets ETF EEM, +1.47% and leveraging the trade one time.
The iShares emerging market ETF has seen inflows of $780.8 million thus far this year, while nearly $4 billion has moved into Vanguard’s EM fund. Investors have poured $1.52 billion into Vanguard’s ex-U.S. fund, while the Total Stock Market ETF has had inflows of $3.6 billion.
Thus far this year, the Total Stock Market ETF is up 6.8%, slightly under the 7.2% rise of the S&P 500 SPX, -0.11% The ex-U.S. fund is up 12.1% on the year.
The Vanguard Emerging Market fund is up nearly 13% thus far in 2017, while the iShares equivalent has surged more than 16%.
The Europe ETF has gained 14.4%, shrugging off such potential headwinds as the recent election in France.
The recent gains could augur for more upside ahead, as “After nearly 17 years, the STOXX Europe 50 Index finally broke above a very significant trendline, signaling a potential major change in trend for European equities,” wrote Ryan Detrick, senior market strategist at LPL Financial. “It is early, and we want to see this breakout hold, but this is another indication better times could finally be coming for Europe.”
European markets were higher recently as investors continued to weigh current political uncertainties and digested fresh corporate earnings. The pan-European Stoxx 600 was 0.18 percent higher with most sectors trading in positive territory. Oil and gas stocks were the worst performers in early deals on U.S. crude stocks data which led to a fall in the oil price. The new figures showed a fall by 1 million barrels last week, according to the Energy Information Administration, but stocks still remain close to a record high.
Basic resources were up by 0.5 percent in early trade. Rio Tinto reported late Wednesday that it was not changing its full-year iron ore shipment guidance despite lower prices. The household sector was also higher early on Thursday on earnings reports.
Unilever reported fresh numbers and rose to the top of the U.K.'s benchmark after announcing first-quarter sales above expectations. Its shares were 1.1 percent higher. The Danish jewellery maker Pandora erased some losses seen earlier this week after saying that it is updating its structure and backing its 2017 guidance. It jumped more than 4 percent in early trade.
British hedge fund Man Group took the lead across European bourses, up by 4.5 percent, after announcing that funds under management rose 10 percent in the first quarter.
Geopolitical tensions between the U.S. and North Korea continue after Secretary of State Rex Tillerson said Wednesday the U.S. was looking at new ways to pressure the rogue state. Meanwhile, he also accused Iran of "alarming ongoing provocations" to disturb countries in the Middle East. In Europe, opinion polls show that the race to elect the next French president is too close to call with both leading candidates losing momentum ahead of Sunday's first-round vote.