Why history suggests emerging-market investors should power through the bear market

Steep drawdowns in emerging markets are common, and they've historically been followed by double-digit gains.

  • By Ryan Vlastelica,
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Emerging-market stocks have been one of the most volatile asset categories in 2018, suffering major losses as investors grapple with severe headwinds.

However, long-term investors in emerging markets should know that such moves are hardly out of the ordinary, and history suggests this volatility could soon reverse course, leading to a sizable move to the upside over the coming year, according to analysts at Charles Schwab.

They looked at the historical performance of emerging-market stocks and found a pattern of steep losses and swift rebounds. In 2018, emerging-market stocks have dropped into a bear market, defined as a 20% drop from a peak. Such losses may be hard to stomach, but they’re quite common; an index of emerging-market equities “has fallen around -20% or more in seven of the past nine years only to rapidly bounce back,” wrote Jeffrey Kleintop, Schwab’s chief global investment strategist.

The history of double-digit percentage losses can be seen in the following chart.

The iShares MSCI Emerging Markets ETF (EEM), an exchange-traded fund that tracks the index analyzed by Kleintop, has dropped about 11% in 2018, and it currently stands roughly 19% below its 52-week high. A similar ETF, the Vanguard FTSE Emerging Markets ETF (VWO) — which tracks a different index of emerging-market equities — is down 11.3% year to date, and it is down 20% from its own peak.

The losses follow an extremely strong 2017, when the funds rose about 30%. According to Kleintop, emerging-market stocks are “about twice as volatile than other equity classes,” though the long-term performance is roughly similar to the U.S. market. Since the inception of the MSCI emerging-market index (.MXEF), it has delivered an annualized total return of about 10.06%, which “exactly matches” a similar index for the U.S. According to Ned Davis Research, the U.S. market undergoes a bear market roughly once every 3.5 years, on average, though the current bull market is by one measure the longest on record.

Thus far in 2018, the S&P 500 (.SPX) has risen 8.6%, and it is within 0.5% of record levels.

The losses in 2018 have come on a number of factors, notably a rising U.S. dollar — a headwind for many emerging markets that borrow in the greenback and then face the higher costs of servicing those debts in their own currencies. The threat of a trade war between the U.S. and its major trading partners, especially China, has only exacerbated that dynamic, by driving investors to seek haven in dollars, further strengthening the world’s reserve currency.

There have also been a number of country-specific issues that have spooked investors, including Turkey’s high levels of debt and inflation and a currency crisis in Argentina, which recently forced the country’s central bank to raise interest rates to 60%. While those issues have garnered a lot of attention, Argentina and Turkey account for less than 1% of the MSCI index, per Schwab.

The losses incurred in 2018 may have made investors gun-shy about diving back into the category of stocks, but Schwab’s data indicates that once the index drops 20%, “it is usually up double-digits just six months later.” The exception, Kleintop added, was during recessions like 2000 or in 2008, where the declines “have been longer and deeper.” The historical rebounds can be seen in the chart below.

The key question for investors is whether that kind of historical trend is likely to recur now, or whether emerging-market stocks may have further room to fall. Kleintop struck a note of caution, writing that “As the global economy nears the end of the current cycle, EM stocks may suffer a prolonged downturn.” He said he was watching to see how the trade tensions between the U.S. and China develop, along with movements in commodity prices and China’s currency, before evaluating their prospects.

However, he did point to some positive signs, including an improvement in economic data. Citing a forecast from the International Monetary Fund, Kleintop wrote that GDP growth in emerging markets is expected to accelerate to 5.1% in 2019 from 4.9% in 2018.

Other analysts struck a more optimistic note.

“Over the past decade, there has been a massive improvement in the quality of emerging-market stocks, but not a massive improvement in valuation. That has created a huge opportunity,” said Andrew Mathewson, a portfolio manager at Martin Currie, who spoke at Legg Mason’s investment forum last week. He was referring to how 10 years ago, emerging-market stocks were heavily overweight on natural-resource companies. Now, the biggest companies include technology, financial, and consumer-discretionary stocks.

“It is a much higher quality asset class than it was a decade ago, and emerging-market growth will remain significantly faster than developed-market growth,” he said. “The story won’t be derailed by one quarter of weak stocks or currencies.”

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