Re-evaluating Emerging Markets & JapanFeb 26, 2019


Re-evaluating Emerging Markets & Japan

In our portfolios, having well-diversified exposures to multiple asset classes, regions, currencies, risk factors, and active and passive vehicles is the first step to achieve our desired outcome over the longer term. However, as opportunities or risks present themselves, we dynamically adjust allocations to try and benefit from our shorter term perspective.

This year we increased our emerging market equity exposure and reduced our Japanese equity exposure. I wanted to share a bit of our team’s insights on the region and provide an overview of our rationale for this shift in our portfolios.

Adding to Emerging Market Equities

Global economic growth peaked in 2018, amidst the backdrop of global central bank tightening and an escalating trade war. These conditions caused many markets to underperform in 2018, but emerging markets suffered more than many developed markets. However, a recent shift from policymakers to more dovish guidance – and easing in the case of the People's Bank of China – has improved the outlook for growth and liquidity in 2019, which should disproportionately benefit emerging markets.

Likewise, recent signals from the Fed also indicate a looser policy that is likely to hamstring the appreciation the USD saw throughout 2018. A cheaper USD should support emerging markets that issue debt in USD and increase capital inflows into emerging markets.

Although emerging markets have seen weaker performance in some of the last 5 years--especially in 2018—there are reasons to believe this trend is changing. Emerging market offer better value, not only relative to history, but also relative to the rest of the world. This implies cyclical risks are more heavily discounted in emerging markets. The combination of improving liquidity conditions, significant valuation discounts and market momentum point to continued emerging market outperformance.

There are however still significant risks in emerging markets. High debt levels are a concern in China and peripheral emerging economies, exacerbated by slowing global growth and trade tensions. Still, spending some more of our risk budget in EMs makes sense to us at this time.

Reducing Exposure to Japan

Our expectation of slowing global growth is likely to hurt Japan disproportionately – given its open economy’s higher relative operating leverage. This will be a challenge for Japanese companies with slowing industrial production and economic growth.

The planned Value-Added Tax (VAT) hike will also dent Japanese growth in 2019, even if preceded by a short-term spending surge. Given Japan’s low growth trend, the last two VAT hikes (1997 & 2014) led to recessions. There will be fiscal offsets this time, but there is a risk of history repeating itself. We feel this warrants short-term caution with our allocation to Japan.

Portfolio Strategy

Our team has a neutral allocation to equities, given the balance of risks in the current late-cycle slowdown. Within equities, we reduced our Japanese exposure to underweight while still maintaining a healthy allocation given the diversification benefits of the local equity market and especially the currency to Canadian investors.

We increased our emerging markets exposure to overweight given valuations and more favorable market environment for the asset class. Depending on how the balance of slowing growth, easier policy and ongoing trade tensions plays out in 2019, these may be tactical trades or represent more long-standing portfolio positions.

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.