How the relationship between emerging and developed markets is changing

The strategic question of emerging versus developed markets is always central to any global investor. As the euro zone’s woes have demonstrated, this has become a lot more complex than a simple “risk on” versus “risk off” binary call.

Take the MSCI Emerging Markets index (EEM, quote) versus the MSCI EAFE (EFA, quote), which essentially maps the developed foreign markets of Western Europe, Australia / New Zealand and the industrialized Far East.

The general rule is that EEM will weaken first, since these economies tend to be more fragile and more reliant on outside capital flows than their larger and more mature counterparts in EFA. As the old saying goes, when Wall Street catches cold, emerging markets get a case of pneumonia.

Likewise, EEM generally hits bottom first and rallies while the slower-moving developed world is still grinding through its vast economic cycle.

Over the last few years, however, this has rarely been the case. Instead, the euro zone’s twists and turns have led global sentiment and EFA up and down for EEM to follow. Where once traders were obsessed with what China was telling us about shifting consumer patterns in Europe, the market now focuses on news from Germany or Australia in search of indicators on what is really going on in China.

The dog and the tail have switched places, or as we might say, the emerging “periphery” is taking on more of the role of the core of the global economy.

In the near term, we can see this in the ratio between EEM and EFA. Back in mid-2007, EEM traded consistently at maybe 50% to 60% of EFA.

After the 2009 recovery got underway, EEM recovered faster and even gained ground so that it now trades at 65% to 80% of EFA.

Right now, EFA and EEM each have an aggregate P/E of about 11, so the emerging markets companies in EEM are about as profitable as those in the developed world.

And in terms of quality, few would argue that EFA has anything like the growth outlook of EEM — or even the stability.

In the short term, EEM is currently trading at 77% the EFA price, which brings the ratio between the portfolios to exactly where we were in late November when the markets bottomed out around Thanksgiving.

Since then, EEM has surged a respectable 18% and EFA has lagged only slightly, up maybe 17.8%.

In the long term, the ratio is definitely near its historical peak of maybe 80% or 81%. But that’s simply the nature of the global baton transfer we have been seeing since before the credit crunch — and that’s why we invest in emerging markets in the first place.

 

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