Stocktake: Emerging markets fall into a bear market

It's bear market time for emerging markets. Rising rates, the strong dollar, trade tensions, and most recently economic crisis in Turkey have helped tip the MSCI Emerging Market index into bear market territory, having fallen more than 20 per cent since late January. Is there value in emerging market stocks? Yes, according to the latest quarterly letter from Ben Inker of GMO, the asset management firm founded by iconic contrarian Jeremy Grantham. For long-term investors, emerging market stocks now represent the "most attractive" asset by a "large margin". In particular, value stocks in the region "are the best asset we can find, by a margin that is just off of the largest we have ever seen".

Inker isn’t fretting about Turkey, which only accounts for about 1 per cent of the MSCI index and which has “long screened” as the country most vulnerable to financial crisis. However, the last quarter was “painful”, he admits, and things may get worse before they better. “Momentum has historically mattered in emerging markets,” says Inker, so there “may be more pain to come in the short term”. Certainly, Merrill Lynch’s latest monthly fund manager survey suggests indices haven’t yet bottomed. Fund managers’ allocations to emerging market stocks have fallen substantially since April, but there was no change over the last month, with positioning remaining at a net – 1 per cent underweight. In contrast, past crises in 2008, 2013 and 2016 climaxed with net underweights of -17, -31 and -33 per cent, respectively. Emerging market stocks are cheap, it seems, but they may well get cheaper.

Cheap car stocks are “trading terribly”

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Ford, GM and Fiat Chrysler all announced profit warnings last month; the bloodletting means the US auto sector was last week trading 8 per cent below its 50-day average, notes Bespoke Investment, making it the S&P 500's worst-performing sector. Globally, car makers have been "trading terribly," says Bespoke, with 17 of the 22 biggest manufacturers in the red this year in the wake of ongoing global trade tensions, weakening car sales and increased spending on technology in order to meet regulatory demands in Europe and the US. Contrarians with strong stomachs may be tempted by increasingly cheap valuations. Mercedes manufacturer Daimler and BMW both trade on just six times earnings. Meanwhile, dividend yields "have gotten pretty elevated", says Bespoke – Hyundai now yields over 8 per cent, Daimler over 7 per cent, with BMW, Nissan, Ford, Renault, and Hyundai all yielding more than 5 per cent.

Fund managers rush into US stocks

Fund managers may be becoming a little too bullish towards the US market, judging by the latest Merrill Lynch fund manager survey. Allocations to US stocks spiked over the last month, hitting their most overweight level since January 2015. Not only that, the US is now the most popular region among investors for the first time in five years. A net 67 per cent say the biggest corporate profits will be found in the US – the highest proportion in 17 years. Merrill's survey is best viewed in a contrarian light; when bullishness hits excessive levels, stocks are at increased risk of a reversal (in April, for example, allocations towards emerging markets hit their highest level in seven years). Overall, investors are certainly not exuberant at present. Cash levels, for example have increased to 5 per cent, well above their five-year average. However, the US may be due a spell of relative underperformance. Fund managers were wary of the US for a long period, and this sceptical sentiment was a tailwind that helped the region to outperform global markets. The latest survey shows that scepticism is well and truly gone.

European profits lag the US

Some bulls would argue investors are right to overweight the US, following another cracking earnings season. A huge 81 per cent of companies beat earnings estimates, noted Barclays, with profits soaring 26 per cent. One-off tax cuts helped, but sales growth of 9 per cent was also healthy, with 68 per cent topping estimates. In contrast, results were “more mixed” in Europe, said Barclays, with only half beating estimates. While the proportion of beats is almost always lower in Europe, investors might be disappointed the beat rate was lower than in previous quarters. One positive sign, however, is that 57 per cent of European companies beat revenue estimates. Still, European companies must be envious of the outsized profit margins enjoyed by their US brethren. US margins hit 11.8 per cent, according to FactSet – the highest level since it began tracking the data in 2008.