I am buying emerging markets thanks to the trade wars

The emerging markets’ valuation seems appealing due to the trade wars and a strong dollar. Trump started trade wars on multiple fronts in early 2018. The Sino-US trade war is the most noticeable one. In May 2018, he announced imposing 25% tariffs on 50-60 billion of Chinese exports. China retaliated immediately by imposing 25% tariffs on $50 billion of US goods. Trump then escalated the trade war in Sept 2008 by imposing 10% tariffs on 200 billion of Chinese exports, which will go up to 25% in Jan 2019. China retaliated again on another $60 billion of US goods.

In early 2018, the stock market became very volatile in anticipation of the trade wars. It dropped over 11% from the peak in Jan. 2018  to the trough in Apr. 2018  The Chinese stock market dropped 25% from the peak in Jan. 2018 to the trough in Sept. 2018. While the US market has pared all the losses and even made a few new highs, the emerging markets have not yet.

Data Source: The Economist  as of Sept. 12 2018

The average age of the US bull market is 7 years. The current one is 9 years old. The pundits have been saying that the average returns of the US stock market for the next decade will be around 4% rather than 10% average annual returns of recent decades. Some people like to brush it off by saying “Hey they have been saying that for the pat 3 years. Look where we are today!”. I would like to argue mean reversion will catch up with the US stocks sooner or later.

The 50% Trump rally since he got elected in 2015 has been mainly fueled by the corporate tax cut.  While there is good chance that the US stock market will rally into 2019 with the tax cut tailwind, the effect will start to dwindle in the future. There will be 2 major headwinds, this trade war and rate hikes. Rate Hikes are always a threat to the stock market historically. Look at the housing market around you for signs of overheating.

The stock market goes up because the corporate earnings go up and vice versa. Rate hikes eat into corporate profits. So do the tariffs. Most companies profit margins are less than 10%, let alone 25%. A slew of companies have already issued warnings about declining profits. Question is how long this trade war will last. if the trade war ends quickly, it will not have too much effect on the looming recession. However, it might be much longer.

Trump believes he is winning on all fronts of the trade war because he tried to gauge China’s pain from the following 2 areas, the Chinese Currency and the Chinese stock market. With the tax cut tailwind on his back, he is rightly so to assume that.

The Chinese currency has devalued almost 10% since the beginning of the trade war. China’s central bank ( PBOC ) did not intervene much because its’ Forex Reserves stood around $3.16 T in Jan. 2018 and around $3.12 T in Aug. 2018.  The PBOC intervened in 2015 using up almost $1T out of its $4T Forex Reserves to defend the exchange rate. It did not do do that this time since the devaluation will offset some of the pains caused by the trade war.

Another reason is that the strong US dollar has attracted a lot of hot money fleeing the emerging markets. However, China immediately clamped down on capital fleeing out of the country. Otherwise, the Chinese Yuan might have tumbled like the Turkish lira which has lost more than 50% over the last year.

The Chinese believe the situation is not as bad as Trump depicted and they can wait for Trump to be voted out of office when the next recession hits. After all, they have a dictator for life now. More importantly, a deep drop in the stock market in the US will have a big impact on its politics. The same thing can not be said for the the Chinese stock market because no one there rely on the stock market like we do here. There is no 401k or any thing remotely equivalent to that.

If Trump can not wring out any concessions from the Chinese, then his tariffs will have achieved nothing but a recession. No manufacturing will come back to the US. They will just move to other low cost countries. Or it would be even worse if the Chinese set up factories in low cost countries to bypass the tariffs. Trumps knows that. My bet is that Trump and the Chinese will meet half way.

EEM , an ETF tracking the emerging markets, has declined 13.3% as of 10/15/2018 for the year and 20% from its’ peak in Jan. 2018

With the record rally in the US stock market,  the stocks here have become very expensive. However, the recent drop in the emerging markets has made their stocks more attractive. Let’s compare 2 ETFs SPY(S&P 500) and EEM (emerging markets).

SPDR S&P 500 ETF Trust
EEM || ISHARES MSCI EMERGING MARKETS

 

EEM consists of companies from different countries. The Chinese and Korean Companies are heavy weights there. EEM’s exposure to China and South Korea is 28.52% and 14.52%. You can see the details here, such as Top 10 Holdings, Country Expose and Sector Exposure. Its’ average annual returns since the inception in 2003 is 11% compared with S&P 500’s 9.92%.

Reward

  1. US stocks are expensive.
  2. EEM is cheap.
  3. My portfolio has no exposure to the international markets
  4. History suggests emerging-market investors should power through the bear market
  5. The trade war probably does not hurt the US and China as much as everyone perceived 
  6. U.S. Stocks Are Dangerously Overvalued: Time To Buy The Emerging Markets

Risk

  1. Strong dollar
  2. Trade Wars
  3. JP Morgan downgrades China stocks, predicts ‘full-blown trade war’ with US

Warren Buffett once said that as an investor, it is wise to be “Fearful when others are greedy and greedy when others are fearful.”. As of this writing, our primary portfolio does not have any exposure to the international markets. It has only a total market index fund and a total bond fund.  I can say our portfolio is even lazier than Boglehead’s lazy portfolios. The emerging markets are on sale now. it is about time.

While I prefer the valuation of EEM to that of SPY, the chart is just too ugly for my taste right now.  Risking a falling knife or trying to catch a bottom is never my game. I am going to wait for the char to smooth out a bit, and then start my accumulation.

Disclosure:  no position in EEM yet .

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