Asset class recap for January
The first month of 2024 witnessed similar themes to what we saw in 2023.
- Interest rates strongly impacted market returns, and
- Large Growth stocks outperformed.
January produced positive returns for Large Cap stocks and Short-Term Bonds, but negative returns for most other asset classes.
The U.S. Federal Reserve elected to not lower rates at their January meeting, throwing cold water on all asset classes, but most severely on asset classes that are highly sensitive to interest rates, including; Small Cap Stocks, Emerging Markets Stocks, Real Estate Stocks, Long-Term Bonds and Intermediate-Term Bonds.
Growth Stocks shrugged off the negative effects of interest rates, as the Russell 1000 Growth index returned 2.5% in January. Industry leaders NVIDIA, Meta (Facebook), Eli Lilly, Netflix and AMD posted returns of over 10%. These are firms that are producing impressive earnings growth and have relatively low debt loads (and therefore lower interest expense to service their debt).
In the three-year return column, one underperforming standout is Emerging Markets Stocks, with a -7.5% annualized return. That return is well below the S&P 500 index return of 11.0%. Three years is not a full market cycle, but this level of underperformance is enough to raise eyebrows, even for staid, long-term investors. More and more investors are asking whether it may be a good idea to reduce or eliminate allocations to Emerging Markets Equities in their portfolios.
Understanding what has caused such severe underperformance can help us to make wise allocation decisions going forward. Fundamental research on the countries that make up the Emerging Markets asset class uncovers a handful of economic drivers that impact the financial success for their corporations. Many are net oil producers. Currencies have an impact on the prices of their exported goods. Interest rates can have an outsized impact on their success. China makes up the largest component of most Emerging Markets indexes. If we perform a multifactor regression that minimizes the sum of squared errors of these factors against the monthly returns for the MSCI Emerging Markets Equity index for the last five years (we often use 60 months as a statistically significant sample size), we find that these factor loadings do the best job of describing the performance of Emerging Equity:
Return = (0.07 x the monthly return for Brent Crude Oil)
+ (0.45 x the monthly return for the S&P 500 index)
+ (-0.02 x the monthly return for the US Dollar index DXY)
+ (-0.42 x the change in the yield for 10 Year Treasury Bonds)
+ (0.38 x the monthly return for the iShares MSCI China ETF with ticker MCHI)
For the last three years, the returns for the factors multiplied by the factor loadings help explain a majority of the underperformance for Emerging Markets Equities versus US Large Cap Stocks.
China is the largest country in emerging markets indexes today making up around 25% of the total index weighting, so it is no surprise it has such a large impact on Emerging Equity returns. Stock returns have been very poor in China as a real estate crisis and COVID have hit their economy particularly hard. Neither of these are bound to persist for a long period of time though. Brent oil costs about $82 / barrel today, in-between recent lows and highs. The Dollar typically becomes less attractive as the U.S. lowers interest rates. Rates are generally expected to drop over the next year. Combining all of these factors gives an overall positive picture for Emerging Markets Equities for the mid-term future, helping us feel comfortable with our current allocations in our portfolios.
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“CRSP” stands for Center for Research in Security Prices. Part of the University of Chicago’s Booth School of Business, the CRSP is a nonprofit organization that is used by academic, commercial, and government agencies to access information such as price, dividends, and rates of returns on stocks.
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