From the desk of Steve Strazza @sstrazza and Louis Sykes @haumicharts
Markets never operate in a static manner. Instead, markets are dynamic and remain in a natural and constant state of flux.
In knowing this, we must always remain flexible and aware of the changing conditions and developments taking place around us. We pride ourselves on our ability to evolve and adapt to these changes in market structure and are never dogmatic in our approach.
For the last decade, US large-cap growth has been where the alpha is, and derivatives of this theme like large over small, stocks over commodities, and US over international have been very powerful relative trends. We know this well because we’ve been leaning on them for a long time…
But that’s all changed recently, as we’ve been vocal about the importance of repositioning and decreasing exposure to growth in favor of more cyclical, value-oriented stocks.
If history is any guide, Emerging Markets should be a major beneficiary of this new environment as outperformance from cyclical areas has always acted as a tailwind for this group in the past. Though over the last few weeks, we haven’t seen this at all.
Instead, as money has rotated out of growth, and value has remained resilient, Emerging Markets have come under increasing pressure. So, what gives?
In our opinion, it all boils down to the following question:
Now that Emerging Markets have such massive exposure to large-cap tech, should we expect its long-term historical correlation with value to break down?
First, let’s set the stage by discussing some of the significant changes in the composition of the Emerging Markets index since the last commodities supercycle in the early 2000s.
Here we’re comparing the sector breakdown of the MSCI Emerging Markets ETF $EEM from February 2004 with what it looks like today.
Click tables & charts to enlarge view.
Growth sectors are colored green, while value are red, and the defensives are blue. I don’t know about you, but I’m seeing a lot more green in the 2021 pie chart as the index’s exposure to tech and discretionary have exploded, increasing by 8% and 15%, respectively.
At the same time, there’s a whole lot less red than there was back in 2004 as the allocation to Materials and Energy have decreased materially.
In 2004, EEM was more or less 50% value and just a measly 20% growth (38.6% if we include stocks that would be classified as Communications today).
Now let’s contrast this with the current weightings in EEM…
Today, an overwhelming 55% of the index is represented by growth stocks while exposure to the value-oriented sectors that used to dominate it has fallen to just 35%.
So, EEM has arguably double the exposure to growth and significantly less exposure to value than it did back in 2004.
For an even more extreme example of the changes that have taken place in this index, let’s look at the Geographical breakdown now.
Once consisting of 45% of the Emerging Market index, the Asia-Pacific region has since ballooned to a whopping 80% of EEM. And of that 80%, half of it is concentrated in just ten large-cap growth names.
Meanwhile, Latin America and Africa, which are more heavily skewed toward value stocks (particularly, Natural Resources and Financials), have shrunk down to just a 15% weighting in EEM. That’s a big shift from the nearly 40% allocation the index had in these areas in 2004.
Long story short, today’s Emerging Markets Index is driven mainly by growth stocks and China.
This marks a significant departure from the value stocks and more cyclical regions that had been responsible for driving gains in this index during the last commodities boom.
The chart below is an excellent representation of this old relationship.
Notice how after the dot-com bubble collapsed and markets started recovering back in the early 2000s, Emerging Markets were leading the charge along with commodities and value stocks.
Now let’s fast forward to the present where we have the first initiation rally of what appears to be a new relative trend in favor of value.
Instead of moving higher with this ratio as the historical correlation would suggest it should, Emerging Markets appear to be registering a failed breakout relative to the S&P 500.
While we recognize this is just a few week’s worth of data, it still represents a notable change in character and is occurring at an important inflection point of a new trend.
Given the new commanding weightings in technology and other growth-oriented sectors, we really shouldn’t expect Emerging Markets at the index level to participate in the same manner as they did during the previous commodities bull market.
So long as this rotation into value remains intact, the way to play EM moving forward will be a bit more nuanced. We want to identify the specific regions within the space with more exposure to cyclicals and bet on them individually as opposed to the index itself.
Let’s take a look at some of these individual Emerging Market countries now.
Where better to start than with the 800-pound gorilla of the group… Here’s the iShares China Large-Cap ETF $FXI falling victim to sellers once again at those key multi-year highs in the 53-54 range.
It’s no surprise to see EEM being dragged down here as China was one of the hardest-hit countries by the recent selloff in growth. As long as growth continues to show weakness, this heavy Chinese exposure is likely to act as a major headwind for the entire index moving forward.
In the meantime, we’ve seen plenty of niche EM countries, particularly those with higher weightings in Financials and cyclicals, continue working higher despite the selling pressure that’s taken place over the trailing month.
Believe it or not, Saudi Arabia has been one of the best performing global markets since the start of February, which is when the rotation into value really started accelerating.
Just look at how closely the Saudi Arabian Tadawul index trades with Crude Oil.
Does Saudi Arabia look like China, which has been dragged down by growth? Or does it look to be benefitting from the money flowing into Commodities?
We’d argue it’s definitely the latter. And with ZERO exposure to Tech in the USD ETF and just 4% to Discretionary, this makes a lot of sense.
The United Arab Emirates is very similar to Saudi Arabia in that a large portion of the country’s GDP is dependent on oil.
The UAE ETF potentially reclaiming this major level definitely isn’t a bearish development.
As long as UAE is above 13, the risk is to the upside.
How about Chile $ECH?
It’s fair to say Chile isn’t harboring the next Silicon Valley just yet, with only 1% of the index represented by Technology. Chile remains very much correlated to Commodities, Energy, and Base Metals.
Given that price is making new 52-week highs, and not selling off along with growth, we can add Chile to the list as another pocket of strength and potential future leader within Emerging Markets.
Here’s a zoomed-in chart with risk levels.
Chile printed a breakaway gap above a confluence of resistance around the 32.50 level this week. As long as we’re above there we’re buyers of ECH with a target at 41.50 over the next 2-4 months and a longer-term target of 56.50.
Going back to the Asian-Pacific now, and Thailand $THD is another country that’s showing some impressive relative strength of late.
If we’re above 81.50 we want to be long THD with a 2-4 month target just above 100.
It may be just a short travel to China, but the two indexes couldn’t be any more different.
The largest sector in THD is Energy at 15%, followed by Financials at 13.5%. The environment couldn’t be better for this kind of exposure.
There aren’t too many countries out there with Energy as their largest sector, which is precisely why Thailand is breaking to new highs. Meanwhile, tech-heavy China is struggling with overhead supply. Which one would you rather own?
In conclusion, not every Emerging Market is made the same.
The typical Commodity-centric and cyclical-driven countries and sectors that once powered the index over a decade ago have had their influence sizeably reduced.
At the index level, Emerging Markets have changed dramatically over the past 15-years, so we simply don’t have enough data to make a call as to whether they will participate to the same level they did in the past cycle.
Diving into the individual Emerging Markets themselves reveals that the strongest countries today are those with predominant weights in cyclical and value-like sectors, such as Financials, Materials, Energy, and Industrials. This should be no surprise considering the backdrop of everything else that’s taking place.
Moving forward, if this rotation we’ve talked so much about continues to ramp up, we’ll be looking to isolate our exposure more and more to these cyclical areas within Emerging Markets as opposed to betting on the broader index itself.
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