Emerging Markets – Stocks OR Bonds. Not both.
Investors are too often advised that Emerging Markets (EM) stocks AND bonds are both the place to be – at the same time.
That’s contradictory advice.
Investors appear to have had it both ways until recently:
|Year-to-Aug 31/11||1 Year||3 Year|
|Emerging Markets bonds (proxy: iShares.ca EMB)||
|Emerging Markets stocks (proxy: iShares.ca EEM)||
(Source: iShares.ca index returns tool).
… But both EM stocks and EM bonds, at the same time? This can’t persist.
The arguments for EM stocks are good ones. (Think higher growth rates relative to developed markets). The arguments for EM bonds are good ones too. (Think higher yields, elevated currencies and stronger fiscal positions).
EM economic growth implies that EM stock prices would continue to rally higher. But growth means inflationary pressures and increased interest rates to arrest them. Increased interest rates are not good for bonds. (And inflation eventually kills growth).
We are already seeing EM’s increase interest rates to do just that – dampen inflation. China has been increasing interest rates for months. India has a flat yield curve. Brazil has had an inverted yield curve for more than two months. (An inverted yield curve is usually a precursor to a recession. Only yesterday, Brazil reduced their interest rates from 12.5% to 12% despite an inflation rate above 7%. Higher rates had elevated the Brazil currency and made Brazilian products less competitive on the global market. High inflation, high rates and an uncompetitive currency are/were slowing Brazil’s economy).
EM bond performance, then, will only continue with a slower growth economic backdrop (brought on by the ‘braking’ effect of higher interest rates). When rates stop rising and perhaps fall is when bond prices should rally further.
A slower growth scenario for EM’s, however, means a pause at least if not weaker EM stock prices.
Investors can’t have it both ways.
Growth means stocks.
Slower growth means bonds.
Don’t expect both EM stocks and EM bonds to perform at the same time.Next time? Risk management. Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan