The strong run in emerging market equities and the relative outperformance of non-US developed market stocks appears to have ended as a weak US housing market weighs down on consumers and credit markets and high commodity prices stoke inflation worldwide.
In fact, the S&P 500 index has actually outperformed both the MSCI EAFE and main emerging market indices since year to date.
European and Japanese stocks, which have done relatively better that US stocks for some time, are suffering both from weaknesses in US consumer demand and the depreciating dollar and from tighter credit conditions and commodity prices at home. Although valuations are attractive, the macroeconomic headwinds are giving investors no reason to break out into a new direction and buy with confidence.
Stocks in emerging markets, by contrast, are being hit mainly by rising inflation, as economic growth remains strong in absolute terms thanks to the continued strength of domestic demand.
"What’s really hurting emerging markets this year is rising inflation," says Alec Young, international equity strategist at Standard & Poor’s Equity Research. "We recommend underweighting emerging Asia, China and India as these markets have the highest valuations in the emerging market universe and are also the most vulnerable to higher inflation and rising interest rates."
When India reported an increase in prices of 11% this June, significantly higher than the 9.8% expected, investors promptly wiped out 3% of the market’s capitalization.
"Investors have really lasered in on the inflation theme in emerging markets," says Young. "This is because higher prices combined with central bank tightening in markets like Brazil and Russia are not positive for equity valuations and will be a drag on performance."
In the US, investors are optimistic that the market might have bottomed out after plunging generously and stocks are trading in a range, looking towards earnings growth, energy prices, the housing market and the Federal Reserve for direction.
The market has also benefited from more than $100 billion-worth of share buybacks in the first quarter of 2008, one of the highest quarterly amounts ever, which could be good for longer-term earnings per share.
The housing market, which still has room to fall and which is at the root of weak consumer confidence and bank write-downs, remains the key variable to watch.
Globally, however, plays on rising commodity prices, such as integrated oil and gas companies and markets heavily geared towards commodities, such as Canada and Latin America, remain the most promising.
"There may be some short-term profit-taking but in the long term we’re still fairly positive," says Young at S&P. "Part of the reason is that if we were to turn negative, we’d have to recommend something else, and given how dire the outlook is elsewhere, we still still think that the commodity-centred markets are the best place for investors to focus in the second half of 2008."