To understand why U.S. equities have outperformed emerging market equities, and may continue to do so, consider the story of the elephants and the mice.
I’m referring to the story that says when elephants fight, mice get crushed. The elephants here are the U.S. and China, which have been locked for nearly two years now in an escalating trade war. The mice are the emerging market economies.
So far this year, for example, the S&P 500 SPX, +1.48% (with dividends) has gained 16.3%, according to FactSet, almost double the 10.7% return of the MSCI Emerging Markets Index ETF EEM, +1.27% . This despite the U.S. stock market being far more overvalued: At the beginning of the year, the cyclically-adjusted P/E ratio (CAPE) of U.S. equities was nearly double that of the emerging market sector (29.9 versus 15.4).
The S&P 500’s outperformance continues a pattern that extends back a decade, furthermore, as you can see from the accompanying chart.
The reason why emerging economies are so vulnerable to an escalating trade war is that a much higher percentage of their economies is dependent on global trade. According to the World Bank, for example, trade as a percentage of U.S. GDP is 27%. For many emerging market economies, in contrast, the percentage is well over 50%.
To document this vulnerability, I fed into my PC’s statistical package an index of world trade compiled by the CPB World Trade Monitor, along with the monthly returns of the SPDR S&P 500 ETF SPY, +1.56% and the MSCI Emerging Markets ETF. World trade was able to explain or predict three times more of the emerging markets’ monthly returns than of the S&P 500’s. (As measured by the r-squared of the ETFs’ monthly correlations.)
There are several important investment implications of this finding. First, if you want to bet on an escalation or de-escalation of the global trade war, emerging market equities are a more speculative bet. This is on both the upside and the downside, of course. So if you thought the trade war would soon lessen or be over altogether, you’d expect emerging market equities to outperform the S&P 500.
But if you thought the trade war was about to get worse, you’d want to favor U.S. domestic equities over emerging market stocks. This is one of the reasons, by the way, that Goldman Sachs recently reduced its exposure to emerging markets.
For example, look at the stock market’s mini-correction that began on July 26. With worries about an escalating trade war, the S&P 500 (with dividends) lost 4.6% (through Aug. 12) while the MSCI Emerging Markets ETF lost 7.8%.
A second implication: If you do invest in emerging markets before the current trade disputes are resolved, you might want to overweight those economies that are the least dependent on world trade. Consider Brazil, for example; trade represents just 29% of its GDP, according to the World Bank — far lower than the average emerging market economy and barely higher than the comparable percentage for the U.S. economy. (Click here for a full list of countries and their comparable percentages.)
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at firstname.lastname@example.org
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