Tied to Trade: What’s Next for Emerging Market Stocks?

A note from Charles Schwab this month talking about the emerging market stock performance and what the future of investing could look like:

Emerging market (EM) stock performance has proven to be highly connected to the timing and details of a potential trade agreement between the United States and China. A wide range of outcomes from -10% to +40% may lie ahead of EM stocks depending on the timing and details of a trade deal.

Tied to trade

There have been clear periods of emerging market stock weakness around periods of trade tension escalation (Oct 2018, May 2019, and August 2019) and rallies around temporary periods of de-escalation (Jan 2019, June 2019, and Oct 2019), as you can see in the chart below.

EM stock performance and periods of trade tension escalation and de-escalation

Source: Charles Schwab, Bloomberg data as of 11/10/2019.    Shaded red periods are times of trade tension escalation and green shaded areas are times of trade tension de-escalation.    Past performance is no guarantee of future results.

During each one of these periods, EM moved more dramatically than either international developed market stocks or U.S. stocks, reflecting EM’s higher volatility and greater sensitivity to the trade environment. During the most recent period of trade tension de-escalation, from October 2 through November 7, EM performance was stronger than either developed international or U.S. stocks (MSCI Emerging Market Index 8.5%, MSCI EAFE Index 7.2%, S&P 500 6.8%).

Three scenarios

What’s next for emerging markets may depend on the outcome and details of a trade deal over the remainder of 2019:

Escalation (EM stocks could fall 10% or more): If the prospects for a cooling of trade tensions, either permanently or temporarily soon fade, then a period of underperformance may be in store as markets pull back, consistent with prior periods . EM stocks may retreat about 10%, as they have in the past. If a total breakdown in trade relations occurs, rather than a temporary flare up in tensions over the details of a deal, the global economy could tip into a recession and worsen the stock market losses beyond the typical 10% pullback.

Phase One (EM stocks could rise another 7-8%): If signs of progress continue and lead up to a “Phase One” trade deal in December, the EM rally and outperformance may extend another month. We last saw this following the sharp rally of 11% in January 2019, EM stocks continued to post less dramatic, but still solid gains over the next two months as signs of progress on a trade deal continued leading to a total gain of 16%. A repeat could double the magnitude of the most recent rally, adding another 7-8% in gains.

Phase Two (EM stocks could gain 20-40%): Further signs of progress on a trade deal beyond Phase One that may reverse nearly all of the trade barriers between the U.S. and China created over the past two years may be a catalyst for larger and longer-term gains by EM stocks. EM valuations, measured by trailing price-to-earnings ratio, is in the bottom third of their 20 year range, pointing to the potential for stronger gains. In contrast, U.S. valuation are near the average of past peaks, typical of a late cycle environment (read more about current valuations here: Are Stocks Priced For Perfection Or Recession?). In the short-term, valuation changes are likely to dominate the move in EM stocks. A rise in the price-to-earnings ratio from currently depressed level in the lower third of the range between cycle highs and lows over the past 20 years to the upper third (more typical for a late cycle growth environment) would suggest the possibility for a further gain of 20-40%.

Historical ranges and current price-to-earnings ratios by global asset class

U.S. based on S&P 500 Index, Int’l based on MSCI EAFE Index, and EM based on MSCI Emerging Market Index.
Period includes 1969 to present for U.S. and International. EM history goes back 25 years to 1995.
“Recession Average” refers to the average price-to-earnings ratio at cycle lows and “Perfection Average” refers to the average ratio at cycle highs.
Source: Charles Schwab, MSCI and Factset data as of 10/11/2019. Originally published here: https://www.schwab.com/resource-center/insights/content/are-stocks-priced-perfection-or-recession

Deal could mean big gains

A substantial trade deal could trigger a sizeable rebound in EM valuations to the upper third of the historical range (usually seen in late cycle environments) based on increasing evidence that the economic downturn in EM may be over, and a late cycle recovery may be sustained by a trade deal. A similar reacceleration of this type occurred most recently in 2016 and 2017, lifting the price-to-earnings ratio of emerging market stocks into the top third of their historical range, resulting in an annualized gain of 39% (from 1/20/16 to 1/26/2018) which outpaced developed international and U.S. stocks.

Current signs of a potential reacceleration can be seen most clearly in the manufacturing purchasing managers index (PMI):

• The EM Manufacturing PMI rose to a six-month high in September and was unchanged at 51.0 in October. The level 50 is the dividing line between contraction and growth, so the current level points to a rebound in EM production.

Manufacturing recovery?

Source: Charles Schwab, Bloomberg data as of 11/10/2019.

• With the largest exposure by country in the index, China’s Caixin Manufacturing PMI rose to a two-year high of 51.7 in October, suggesting growth in China has picked up.
• The most trade sensitive component of the PMI, New Export Orders, rebounded in October suggesting a gradual rise in EM export growth.

EM stocks may benefit from reaccelerating domestic and global growth along with a cyclical rebound in commodity prices, which could more than offset the potential negative impact of the Fed shifting its bias back toward raising interest rates, as was the case in 2016-17.

Clearly, the near-term direction for EM stocks depends on the form of trade deal that emerges in the next month or two. EM stocks are vulnerable to a 10% or more pullback if hopes for a deal are dashed once again. But further gains could be in store in the event of a Phase One and broader Phase Two deal. The nature of trade negotiations make this hard to predict, so we will be watching the developments closely.