Why own Emerging Bonds & Stocks? – Their performance is terrible as of late!

As you look at your current quarterly reports you will notice an under performance in all four of our model portfolios relative to the domestic markets and the risk adjusted returns. This under performance is due to our emerging markets allocation of bonds (down 6-9% for Q2) and emerging stocks (down 8-9% for Q2). At this same time domestic stocks rallied late in the quarter to end up a positive 3-4%. My math says that is a 9% to 13% difference in performance relative to having all of your money invested in U.S. equities. Exposures in these asset classes range from 16% to 21% of your portfolio which means that it hurt our performance by a factor of approximately 2.8% to 3.8%. Ouch!

So the question is, with interest rates going up worldwide and the dollar appreciating against other currencies, why own Emerging Bonds or Stocks? The reason is simple, strategic asset allocation. If you have all of your money going up, all of it could be going down. I have listed below four specific reasons to be PATIENT with our emerging exposures.

1. Rising Importance in global economy. Emerging markets represent just 12% of the world total stock market while these nations now represent 36% of global economic growth according to recent IMF estimates.
2. Improving fiscal management in both governments and corporations. Emerging market stocks have a higher return on equity (15%) when compared to domestic stocks (13%) and are currently paying a higher dividend rate too (2.7% vs. 2.1% for the S&P 500). Meanwhile, emerging market bonds have evolved over the past decade. Currently, over 62% of the EM government bonds and 71% of EM corporate bonds are rated investment grade. Emerging market nations hold 80% of the world’s foreign exchange reserves and as a group have de-to-GDP ratios less than half of the U.S., Europe and Japan.
3. Best performing stock and bond asset classes long-term. Despite the vastly improved quality of the stocks and bonds in the EM asset class, they can still be volatile, as evidenced last quarter. But over the long-term these investments have delivered. During the last decade EM stocks returned 13.1% annually, outperforming the 7.5% return for the S&P 500 domestic index. Meanwhile EM bonds have returned 9.1% versus the 4.6% annual return for the domestic Barclays Aggregate bond index. Fundamentals pay-off over the long-term, not necessarily each quarter!
4. Current valuations remain attractive to developed markets. Perhaps, more importantly, where do EM stocks and bonds go from here? Just as the U.S., Europe and Japan, these economies are undergoing various structural changes. However, EM stocks are roughly 30% cheaper than domestic stocks right now and EM bonds provide one of the few sources of improving credit quality bonds with attractive yields for fixed income investors.

Please give us a call if you have any further questions or concerns. We truly believe that these inversely correlated assets will come back to benefit us in the next twelve months. Sir John Templeton, a wise money manager that I learned much of our value driven discipline from was quoted, “The only investors who should not diversify are those that are right 100% of the time.” Not possible!