Today, EM stocks are trading cheaply and showing robust 12-month price momentum. This positive positioning combined with improving underlying economic fundamentals in EM economies provide investors a good opportunity to increase allocations to this arena.
Price momentum. Obviously, an acknowledged tension exists between momentum investing, or trend following, which can be (very briefly!) profitable, and performance chasing, which is arguably the most damaging error in the world of investing. The most basic trend-following strategy is buying assets with strong one-year returns and shorting assets with poor one-year returns. Such an approach, particularly when diversified across markets and asset classes, has delivered a significant historical return premium (Hurst, Ooi, and Pedersen, 2012).
Such a strategy is successful and differs from performance chasing because it has a sell discipline. To profit with momentum, an investor has to be willing to eliminate long holdings as soon as they stop soaring, and short positions as soon as they stop plunging. Some 200 years ago, the classical British economist David Ricardo advised investors to “cut short your losses” and “let your profits run on.” That advice could not be truer today, and if followed, imposes the discipline needed on a trend-following investor to be as successful as possible. Therefore, a momentum strategy works best when paired with a buy-low/sell-high value discipline.
Certainly, recent price momentum in emerging markets has taken a hit in November following the US presidential election. The prevailing narrative had been a Trump win would devastate global markets. Is it any surprise that a universal consensus was wrong? Now the narrative suggests Trump will be awful for trade and will wreck the emerging economies. Any bets on whether this universal consensus is any better than the last one?
In any case, even with the mild correction in emerging markets since the election, trailing 12-month momentum is poised to improve, not erode: the free fall that occurred in December 2015 and January 2016 will be removed from year-over-year returns in the weeks ahead, which will serve to strengthen the 12-month momentum signal.
Economic momentum. Some investors use recent price momentum as their sole source of information about future return prospects, but in doing so they run the risk of allowing entirely random price fluctuations to drive perceptions. To avoid this pitfall we consult an internally developed business-cycle model based on select macroeconomic and monetary policy indicators, discussed in more detail in Aked, Mazzoleni, and Shakernia (2016).
Our model’s business-cycle slowdown probabilities for emerging economies shows a 68% correlation with recent price momentum. As the probability of an economic slowdown falls, equity prices tend to rise and vice versa, suggesting that markets gauge future economic prospects as, or even before, they materialize. The probability of economic slowdown in the emerging markets remains above neutral at 54% through November.
Why, then, are 12-month price returns positive? The answer is that good news isn’t required to ignite a bull market. Sometimes simply less bad news is enough to provide the needed spark. With slowdown risks falling considerably from their 2015 highs of 67%, “less bad” has indeed triggered a fairly powerful rebound. We do not mean to say that EM economies now possess low economic risk or that they are immune to future shocks. In fact, the current elevated slowdown probabilities of these nations, and the uncertainty they encapsulate, likely explain why EM assets remain so attractively priced today.