Finding Relative Value in Emerging Markets

Finding Relative Value in Emerging Markets

Jacob and Roger explain why, given the current level of uncertainty, it might be wise to look at relative value opportunities within emerging markets.

Research
Research

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MACRO

by Roger Hirst

Absolute Risks, Relative Opportunities

The crisis triggered by the collapse of Silicon Valley Bank (SVB) reflects the ongoing risks of a market that is digesting the confluence of inflation risks on one hand and economic growth risks on the other.

Relative value trades may be one way that investors can mitigate these risks.

Today’s investment landscape has been a long time in the making:

  • The foundations were laid by the loose monetary policy of the last decade.
  • Risk-taking was then supercharged by the pandemic policy response.
  • This edifice was then undermined by the surge in inflation, yields, and interest rates.

We’ve been making the case for a while now that uncertainty is rising. That said, we urge our readers to move past all the noise that stems from such periods of high volatility, which will inevitably mean revert. For longer-term investors, the biggest risk is not short-term asset price volatility, but lengthy periods of economic volatility, where the cycles are shortened, making investible trends fleeting and harder to capitalize on.

The most pressing questions to ask right now are:

  • Does the current and future policy response to everything that is happening imply higher periods of economic volatility (i.e., inflation) going forward?
  • Does the response from central banks imply that inflation might trend higher, again, in the foreseeable future?

This matters because:

  • Higher inflation makes the correlation between bonds and stock returns positive, which creates a problem for classic buy-and-hold strategies like the 60/40 portfolio.
  • In fact, the trailing 3-Year correlation of stock and bond returns has turned positive for the first time since November 2000.
  • Such an environment favors relative value strategies that focus on finding opportunities that generate positive returns even when markets are trending down or sideways (which is likely to happen in a higher inflation scenario).

Emerging markets are one area that could provide investors with a wide variety of opportunities that are relatively, but not exclusively, less correlated with developed markets.

Now, we know that very few emerging markets will fully escape the direction of travel defined by developed markets, and that’s because developed market investors remain a major source of investible capital for emerging markets (the broad-based emerging market space will therefore ebb and flow with the rise and fall of capital in developed markets). But divergences within different emerging markets can provide investors with relative value opportunities, and thus with the ability to generate returns independently of where the market goes.

Let's get into it...