Investors seem a bit too eager to tout emerging-market (EM) equities. Much as they did with technology stocks during the early-2000s, investors today are looking for the best re-entry point. Data clearly no longer supports the notion that emerging markets are a superior growth story, yet investors seem to be ignoring the classic warnings signs for fear of missing out.

One such classic warning sign is the slope of the yield curve. Historically, steeper yield curves (i.e., wider 10-year to 2-year spread) have been reliable forecasters of stronger overall nominal economic growth and stronger profits growth. Bigger yield differentials encourage banks to lend and investors to take more risk. Inverted yield curves, however, have historically been good predictors of recessions. An inverted yield curve signals the central bank may have tightened monetary policy too much, and it may be wiser to hoard funds than to lend them. The economy tends to slow after the yield curve inverts, and the probability of a recession significantly increases.

US yield curves remain extraordinarily steep. Currently the slope of the 10 year to 2 year yield curve is around 230 basis points, which is about 1½ standard deviations* above its normal steepness (roughly 95 basis points based on data from January 1979 through March 2014). This suggests there is ample liquidity in the economy, and bank lending has indeed begun to accelerate. The U.S. curve is not as steep as it was, but it remains very steep by historical standards (see Chart 1)

 

 

Emerging-market yield curves tell a very different and disconcerting story. There is plenty of liquidity presently in the global financial markets, and there are not many flat or inverted yield curves around the world. However, with the exception of Japan and Switzerland, the emerging markets are home to all the world’s flat or inverted yield curves* (see Chart 2).

 

 

 

Thus, the liquidity backdrop in many emerging markets still appears to be deteriorating rather than improving as many investors suggest. Earnings growth in these markets is not strong enough to offset increasingly poor liquidity. Emerging-market earnings growth continues to disappoint. As we’ve highlighted in the past, emerging-market companies continue to lead the world in negative earnings surprises (See Chart 3). It is hard for us to imagine that emerging-market stocks will outperform when liquidity conditions are tightening and earnings continue to disappoint.

More than four years ago we began to think the U.S. was entering one of the biggest bull markets in our careers, but investors should be very wary of emerging markets. Nothing in our indicators suggests a change in that position. If liquidity were abundant and earnings growth were healthy, we’d readily invest in the emerging markets. Unfortunately, based on our observations, those characteristics are in the U.S. and other developed markets and definitively not in emerging markets.

*Yield curves below the 100bps are generally considered to be flatter, which implies a higher probability of inverting in the near-term. An inverted yield curve occurs when a country’s 10 year sovereign bond yields less than its 2 year bond.

Index descriptions

The following descriptions, while believed to be accurate are, in some cases, abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indexes. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website.

The past performance of an index is no guarantee of future results.

Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indexes are not actively managed and investors cannot invest directly in the indexes.

U.S. Large Cap: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.

U.S. Mid Cap: Standard & Poor’s (S&P) 400 Index: The S&P MidCap 400 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the mid-sized companies of the U.S. stock market.

U.S. Small Cap: Standard and Poor’s SmallCap 600 Index: The S&P Smallcap 600 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the small-cap segment of the U.S. stock market.

World: MSCI All Country World Index (ACWI). The MSCI ACWI is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of global developed and emerging markets.

EM: MSCI Emerging Markets (EM) Index. The MSCI EM Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of emerging markets.

EM Europe: MSCI Emerging Europe Index. The MSCI EM Europe Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of emerging markets in Europe.

EM LATAM: MSCI Emerging Latin America Index. The MSCI EM LATAM Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of emerging markets in Latin America.

Japan: Nikkei: The Nikkei 225 (NKY) Index: The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949.

BRIC: MSCI BRIC Index. The MSCI BRIC Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity market performance of the following four emerging-market country indexes: Brazil, Russia, India and China.

About Risk
Equity investing is subject to stock market volatility. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, established companies. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging or frontier countries, these risks may be more significant. The value of commodities investments will generally be affected by overall market movements and factors specific to a particular industry or commodity, including weather, embargoes, tariffs, or health, political, international and regulatory developments. An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. As interest rates rise, the value of certain income investments is likely to decline. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, established companies. Investing involves risks including possible loss of principal.

 

©2014 Richard Bernstein Advisors LLC. All rights reserved.

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