April was yet another reminder that what may seem like a sure thing in the financial markets often isn’t, as many popular investment bets reversed during the month. In the minds of many investors, the U.S. dollar is destined to climb higher, particularly as the Federal Reserve inches toward raising interest rates. While this may be the case, the dollar slumped in April. The U.S. economy—the relative standout among its global developed peers—posted disappointing first quarter GDP growth in April (coming in at a 0.2% annualized rate), though harsh winter weather likely bears some responsibility. Consumer confidence also fell in April. Meanwhile, hopes abound that Europe’s economy is on firmer footing as measures such as availability of credit improved. And finally, oil prices have been in a dramatic downward trend but reversed sharply upward in April. The extent to which any of these trends will persist over the near term is not predictable, which underscores the importance of investing with a disciplined, fundamental, long-term approach.
Against this backdrop, asset class returns remained consistent with the first quarter, as international stocks tacked on to their year-to-date lead. Developed international markets gained nearly 4% and emerging markets returned over 7% (respective benchmarks shown in the adjacent table). Large-cap U.S. stocks were up about 1% for the month.
The 10-year Treasury yield rose during the month, while intermediate-term bond returns dipped a slight 0.4%. High-yield bonds gained 1.2% and floating-rate loans returned 0.9%.
We are not going to pretend that we have accurately assessed and quantified all the variables that could impact key fundamentals, such as earnings growth and valuation multiples, across the diverse set of emerging-market countries. But we do believe this bearish scenario return is a good estimate and adequately factors in the potential that emerging markets overearned due to unusually strong China-driven growth that also contributed to a positive commodity cycle—all of which has been going in the reverse direction in recent years. To arrive at this number, we assume that emerging markets may have started overearning relative to normalized earnings potential going as far back as 2005, and from then on we assume around mid-single-digit earnings growth (nominal), which is roughly half the annualized trend earnings growth rate for emerging markets over the 20 years of history we have, which includes both over- and underearning periods.
We are getting decent returns for emerging-markets equities even when using what we think are pretty conservative numbers. But they are not high enough in absolute and relative terms to increase our allocations. The upside in the more neutral or positive scenarios is significant, though, and could be realized if China is able to avoid a major financial crisis while it absorbs the losses stemming from its credit boom and past bad investments. Thus far, they have implemented policies that should be a positive over the long term for their economy. Meanwhile, the unwinding of the credit boom will probably be a drag on their economy and the rest of the emerging markets for some time.
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