The ETF Portfolio Strategist: 26 May 2021

Trend Watch

Emerging markets are on the radar for global asset allocation strategies these days on the assumption that these countries will be the main beneficiaries of the vaccine-led global economic recovery. It’s an intriguing narrative and not without merit, but so far the results are mixed, based on looking at a broad-brush proxy for EM stocks.

Vanguard FTSE Emerging Markets (VWO) continues to move sideways this year after a strong rebound in 2020 following the coronavirus crash. The recovery narrative isn’t dead, but for the moment it remains on hiatus via VWO.

Earlier this year, VWO was outperforming its developed-market counterparts ex-US by a wide margin. But the party reversed and Vanguard FTSE Developed Markets (VEA) is now well ahead in the 2021 horse race, rising 11.0% year to date vs. 6.9% for VWO. It doesn’t hurt that VEA’s gains this year have relatively consistent.

Some analysts worry that the EM outlook remains clouded because of relatively high debt levels. “With the pandemic, debt rose across all types ... the big increase of course was in government debt — and no surprise because of such a need to provide fiscal stimulus at the same time the tax revenues were down much across the board around the world,” says Steve Cochrane, chief Asia-Pacific economist at Moody’s Analytics. “The real impact, however, I think is sort of an increasing divide between developed economies and emerging markets. The debt loads rose most in emerging markets and they may have the most difficulty in terms of taking care of this debt going forward.”

Perhaps, but the EM drag is starting to look appealing to some observers. “Asia or emerging markets (EMs) equities significantly underperformed global peers in the last six months and some of the valuation excess has abated,” advise analysts at Morgan Stanley. “We therefore now move equal weight (rating) on EM versus DM (developed markets) equities in aggregate, with Europe the most preferred global equity region across the strategy team.”

Based on VWO and VEA, however, Mr. Market still prefers developed over emerging. The preference is particularly conspicuous over the past three months:

What’s the logic behind favoring DM? The ING Weekly Economic Activity Indicator for the Europe (the main slice of ex-US DM) offers a clue:

Our nowcast index has been trending upwards for quite some time now. In the week ending 8 May, the index reached 102.1, which was the highest reading since early March 2020, so around the start of the pandemic in Europe. It dropped slightly to 99.8 in the week after, but remains at levels last seen before the second wave. ■