Volatility is…Normal

Following what was a steady climb in 2013, global equity markets have finally hit a modest rough patch. Concerns surrounding the pace of Chinese growth, the impact of reduced quantitative-easing (QE) stimulus from the Federal Reserve (Fed) and the health of corporate earnings culminated in a sudden shift of investor optimism last week. Global stock markets declined more than 2% in the week. Year-to-date results are down nearly 3% with emerging markets (EM) stocks leading the decline, falling over 5% since the beginning of the year. While watching the numbers drop is unsettling, none of this comes as a surprise. Pullbacks are a normal and expected part of market movements.

SEI’s Active Positioning: Emerging Markets

Within our active asset allocation program, SEI initiated an overweight toward EM equities in the second-half of 2013, as valuations appeared to reflect many of the fundamental problems plaguing developing countries—poor economic fundamentals, worries over excessive government and/or private debt levels (China, Turkey and Brazil), and fears of a reduction in the Fed’s stimulus efforts (tapering of quantitative easing)..

Although the recent volatility runs against our expectations that we would see some stabilization of performance versus developed markets owing to the wide valuation gap, we are maintaining our overweight to EM equities. Our logic is based on anticipation of a rebound as governments of developing economies raise rates to stem capital outflows and push through reforms to stabilize their economies.

We recognize that a number of factors are currently tempering investors’ views of the asset class, including the ramifications of higher yields in the U.S. from the Fed‘s bond-purchase tapering, China’s rising debt and its impact on economic growth, and political uncertainty, as well as social unrest, in many regions. However, we also note that sentiment can often overshoot to the downside, at times leading to valuation anomalies and presenting opportunities for active managers.

Merrill Lynch’s latest Fund Manager Survey shows a strongly negative position against emerging markets versus developed, even though global growth expectations are close to the previous highs in 2007. Investors are also ignoring the fact that EM economies continue to produce more positive economic surprises than developed-market (DM) economies. Exhibit 1 illustrates the major divergence between relative EM and DM economic surprises and the relative performance of EM and DM equities.

Exhibit 1: Surprise in Relative Performance

_{Source: FactSet; EM Relative to DM represents the ratio of MSCI Emerging Markets Total Return Index to the MSCI The World Index Total Return; daily data ending 1/24/14.}

SEI believes catalysts will materialize that should improve the outlook for the asset class. Accordingly, we continue to view EM equities favorably. Potential catalysts include an acceleration of global economic growth, a successful conclusion to the Transpacific Partnership (a new trade agreement between the U.S., Canada, Australia, Japan and key Asian countries), an easing of the Chinese debt problem, and economic reforms in some of the larger EM countries, including China, India and Brazil. Longer term, we believe the asset class remains positioned to perform well. Emerging economies should continue to post faster growth relative to advanced economies as trade flows recover. They also should benefit from the expansion of an increasingly affluent middle class, and enjoy generally positive demographic profiles. For now, emotional, indiscriminate selling seems to be ruling the day when it comes to EM stocks, bonds and currencies.

Within emerging-market debt, market pressures have driven yield spreads wider, to approximately 342 basis points (for U.S. dollar-denominated debt) from a little over 300 basis points at year end. Despite the market movement, issuance has been strong year-to-date and generally oversubscribed, despite reported asset-class outflows by retail investors. Yields for U.S. dollar- denominated debt are in the 6% range.

We remain neutral relative to our strategic target weights on EM debt given the shift in sentiment in recent weeks, which could create more downside risk despite the fairly attractive valuations. Political and economic events across all regions have reignited concerns that could weigh on the asset class in the near term. The 2014 election calendar is busy for many nations, which historically has been associated with increased price gyrations.  

A Broader Perspective

While the negative momentum in EM assets has been in place since mid-2011, the correction in developed market stocks is something we haven’t seen for awhile. In our latest quarterly outlook, we noted the extreme bullishness exhibited by investors at the close of 2013. This does not mean that a bear market is around the corner, but the extreme bullishness does indicate a certain vulnerability to negative surprises.

The market may very well be in a period where investors are resetting their expectations, given heightened near- term volatility. In our view, however, we do not believe the elements of a more serious equity bear market are in place. The most important drivers of stock-market performance in our framework are still flashing neutral-to-positive signals.

First, despite the taper, the Fed is maintaining its easy monetary policy—a near-zero interest-rate target and continued quantitative easing. It is our belief that the Fed will keep short-term interest rates well-anchored into 2015, if not beyond. The yield curve (Exhibit 2) should therefore stay steeply upward sloping. Bear markets usually begin when the yield curve flattens and inverts, since an inverted yield curve is a sign of tight liquidity and impending economic recession. At the moment, any flattening in the yield curve reflects a risk-off move by investors, not a tightening by the central bank.

Exhibit 2: U.S. Treasury Yield Curve (%)