Tyler Mordy, president and CIO of Forstrong Global Asset Management
Focus: ETFs

MARKET OUTLOOK

For investors with a positive outlook on global growth, today’s central question is whether to chase U.S. equity prices ever-higher or rotate into global markets such as emerging markets, Europe or Japan.

The U.S. dollar and U.S. equities are now nearly “priced for perfection,” reflecting ten years of excellent economic and financial performance. But the basic fundamentals of the U.S. markets could not be less attractive. Its equity market is extremely expensive relative to the rest of the world, the U.S. dollar is overvalued, its fiscal policy is entirely inappropriate and its tightening monetary policy is prone to triggering high interest-rate sensitivity.

Emerging markets are at the opposite extreme. Many investors see them as vulnerable to U.S. protectionism, contagion risks and moderating growth. But this view simply extrapolates the emerging market experience of the 1980s and 1990s to the present. This is a mistake. Most emerging market economies are much more shock-resistant than previous, owing to a whole host of improving macroeconomic factors: the emergence of domestic pension systems (which reduces reliance on foreign funding), improved trade balances, better fiscal positions and a number of other strong secular growth drivers.

What about valuations? Here, more good news exists. Emerging market stocks trade at wide discounts to their developed market counterparts: a one-third discount on a price-to-book ratio and a 25 per cent discount on forward price-to-earnings multiples. Emerging market debt presents good value, offering higher yields than the U.S. high yield space, with higher credit quality. Emerging market currencies can also only be described as a “deep-value” play. Remarkably, emerging market nominal exchange rates are roughly 40 per cent lower today than during the 2008 global financial crisis.

What about trade wars? Here, the U.S.’s enthusiasm for trade brinksmanship will almost certainly be self-defeating. It's akin to the proverbial boiling frog: The damage to their own economy will be gradual with them unaware they’re being “boiled” until it’s too late. Host countries could easily retaliate and make the business environment much less hospitable. What’s more, countries outside the U.S. could shift their import demand. Over the long run, emerging markets will very likely see a redistributive effect, whereby China shifts their import demand away from the U.S. towards emerging markets.

In the short-term, there’s also now room for plenty of upside surprises. Trump’s policy U-turns are not a bug, but a feature (like with North Korea, NAFTA, the European Union and other files). A retreat from full-scale trade wars is highly likely. Policymakers outside of the U.S. are now countering the uncertainty of trade tensions with their own expansionary policies. For example, China is now easing both monetary and fiscal policy.

Lastly, emerging markets are deeply oversold. Emerging market currency volatility has spiked to levels last seen during 2008’s financial crisis. But is this extreme response justified? After all, despite a flare-up in trade tensions, the fundamental outlook for emerging markets hasn’t materially changed this year. Spikes in volatility as extreme as this tend to be short-lived and are almost always followed by significant rallies. We therefore theorize that much of the pressure for emerging markets is over. We’re only in the foothills of a longer-running period of emerging market outperformance.

TOP PICKS

XTRACKERS HARVEST CSI 300 CHINA A-SHARES ETF (ASHR.N)
Most recent purchase: July 3, 2018 at US$25.62.

With China at the epicenter of U.S trade tensions, Chinese onshore “A-share” equities have been pummeled into a bear market. The question now is, with Chinese equities oversold and trading at attractive valuations, are there reasons to maintain a longer-term constructive outlook?

We think so for a number of reasons. Firstly, the Chinese government and the People's Bank of China have already started loosening fiscal and monetary policy to help combat the impact of trade tariffs. The economic benefits of such stimuli tend to show up with a lag. Furthermore, the recent devaluation of the Chinese yuan will help cushion the blow and leave China’s non-U.S. exports more competitive.

Lastly, A-shares were included in MSCI’s bellwether emerging markets index last June. However, the inclusion was more of a symbolic victory than a game-changing one, as A-shares represented less than a 1 per cent weight in the index by August 2018. For comparison, full inclusion would represent approximately 17 per cent of the index. MSCI still wants to see progress on numerous fronts, including internationally traded index futures, a reduction in trading suspensions and an increasing (or a removal) of trading quotas for foreign investors. Thus, MSCI’s gradual inclusion approach can be viewed favourably, as it provides a win for China’s market reform efforts, will spur new (albeit modest) inflows, continue to incentivize financial market liberalization and better regulation, and provide upside as A-shares move towards full inclusion.

ISHARES JPMORGAN EM LOCAL CURRENCY BOND ETF (LEMB.N)
Most recent purchase: Sep. 4, 2018 at US$41.59.

Sovereign bond yields across the emerging world have come under significant pressure lately, as trade tensions and contagion fears emanating out of Turkey and Argentina have spurred outflows from the asset class. Emerging market currencies have also sold off, compounding losses on local currency debt.

The good news is that, with the exception of a few weak links, emerging markets as a whole are much more economically resilient than they were during both the Asian financial crisis in the late 1990s and the global financial crisis ten years ago. On aggregate, emerging markets have built up foreign exchange reserves, developed more prudent fiscal spending frameworks, adopted flexible exchange rates and strengthened property rights.

With only small linkages between Turkey and Argentina to the rest of the emerging market universe, the risk of contagion is relatively low. It is therefore likely that emerging markets have been sold somewhat indiscriminately and that trade risks have been fully priced into the market. With attractive yields and undervalued currencies, local currency emerging market government debt presents a compelling opportunity.

ISHARES MSCI EAFE SMALL-CAP ETF (SCZ.OQ)
Most recent purchase: June 20, 2018 at US$64.94.

The U.S. equity market has outperformed the rest of the developed world since 2009. This trend is starting to look long in the tooth, with the U.S economy approaching capacity constraints, the U.S. dollar being overvalued and more attractive monetary conditions in Europe and Japan. Additionally, U.S. equities carry expensive valuations, which have been supported by an unsustainable surge in earnings growth following the 2017 tax cuts.

Poor performance since the financial crisis has left plenty of slack in the Europe and Asia, allowing for an extended period of catch-up growth without a great risk of overheating. EAFE small-caps represent a high beta play on a reversal of U.S. outperformance, as smaller companies stand to make large gains from an improving credit environment and consumer confidence. The small-cap space tilts to towards a more cyclical sectoral composition and avoids the increasing scrutiny being placed on large-cap multinationals from a tax and operational perspective.