Emerging Market Crises
This is part 2 in a series on emerging market crises. To download the full 55-page report, click on the link at the bottom of this research note.
After a stock market has lost half of its value, investors may be hesitant to put money into play. But Yale professor William Goetzmann argues that these catastrophic crisis events for individual countries are exactly when investors should be pouring money into the market. Goetzmann studied 101 global stock markets from 1692 to 2015 and theorized that >50% drawdowns represented “negative bubbles” after which equity returns tended to be very high.
Figure 1: Annual Return after Specified Previous-Year Return
Investors were unlikely to realize significant gains after lesser crises, but the true fire sales were handsomely rewarded. Given this research, what is the best way to execute an EM crisis investing strategy after investors have fled to the most liquid assets in global and emerging markets? And are there better, more practical, and more logical ways to exploit this than simply buying the EM indices at different times in history?
We analyzed 24-month forward returns for stocks and bonds in 71 crisis situations across 18 target markets. We differentiated between idiosyncratic and global crises. We found that EM equities outperformed EM debt and US equities and treasuries in global crises, when capital pull from emerging markets is at its highest. Focusing on countries that had experienced >50% drawdowns (shown as Country Equity below), or investing in large value stocks, performance was even better than the broad EM index.
Figure 2: 2-Year Returns by Financial Instrument in Global Crises, 1987 (or Earliest Available Data) to 2020
Source: Capital IQ, Global Financial Data, Ken French Data Library
EM sovereign debt outperformed all other instruments during idiosyncratic crises, with a strategy focused on countries whose equity markets had experienced a >50% drawdown performing the best (shown as Country Sovereign Debt in the below chart).
Figure 3: 2-Year Returns by Financial Instrument in Idiosyncratic Crises, 1987 (or Earliest Available Data) to 2020
Source: Capital IQ, Global Financial Data, Ken French Data Library
Below we contrast equity and debt performance, including for the value segment, in the US and emerging markets, going into more depth on the winning strategies.
Equities
Global Crises
We wanted to answer if emerging markets or the US would have generated better returns during global crises. We compared EM country equity indices and the EM Large Value index to the S&P 500. We show return and recovery profiles for these strategies below.
Figure 4: 2-Year Return and Recovery, US vs. EM Equities in Global Crises, 1987–2020
Investors appear to have been handsomely rewarded for investing in emerging markets during global financial crises. EM country equities have historically generated 4x the returns of the S&P 500 in the 24 months after global crises. Most importantly, emerging market equities have historically displayed a superior recovery rate compared to the already high rate of the S&P 500. And EM value investing did even better, we found.
Idiosyncratic Crises
We also wanted to look at those crises that were idiosyncratic to emerging markets. For each idiosyncratic crisis in our target EM markets, we wanted to compare the returns from investing in that country’s equity index for two years to those from investing in alternative instruments: EM Large Value, and the S&P 500. Below we show the average returns for all idiosyncratic crises across all countries.
When global liquidity dries up quite indiscriminately in a crisis, local EM market indices and value portfolios are some of the best equity investment opportunities, we believe. When global crises unfold, foreign investors typically pull out capital from emerging markets either in defense or to deploy invest that capital into their home countries during unfolding domestic crises. Emerging markets are thus starved for liquidity, which further amplifies the drawdowns that were initially set in motion by the global crisis. These drawdowns translate into ever cheaper stocks and bonds for the few investors that enter positions in these markets and take advantage of the likely rebound.
Figure 5: 2-Year Average Return and Recovery, US vs. EM Equities in Idiosyncratic EM Crises, 1987–2020
Source: Capital IQ
Like investing in global crises, we found that investors can potentially expect attractive returns from investing in country equities during idiosyncratic EM crises, but not in value portfolios. However, the S&P 500 has a higher recovery rate – this is not a low-risk investment.
Comparison to Buy-and-Hold Strategy
Finally, we wanted to check what percentage of total emerging markets returns are captured by investing in crises.
We compared the returns from a buy-and-hold strategy in our target markets to those from investing “in and out” of crises. For example, let’s assume an index went from 100 to 200, generating 100% return over 30 years. There were two crises during that period: in one the index went up 50%, and in the second it went up 25%. Investing only during those two crises and holding the investment for 24 months would have generated a compound return of 87.5%, thus capturing 87.5% of the total gain in only 4 years instead of 30, according to our research.
On average, we found that an investor could have achieved 185% of the buy-and-hold strategy across countries by investing in crises over 24 months. However, crisis investing only outperformed in 28% of the countries. This is because crisis investing worked particularly well in a few countries, such as Turkey, Russia, or Korea (See Appendix Figure 11).
Conclusion
Investors can potentially expect a higher return from investing in EM equities during crises compared to investing in the United States. EM investing in global crises seems particularly rewarding to investors. While country-level returns were historically a whopping 4x higher compared to the S&P 500, they have also had higher recovery rates. This is different for idiosyncratic crises, when higher returns from country-level EM equities are accompanied by higher risk. Value investing has also historically performed better in emerging markets compared to the United States in times of crisis.
Debt
We wanted to understand how debt performed relative to equities in emerging markets. We looked at MSCI Emerging Markets Equity Index starting in 1989 and J.P. Morgan Emerging Markets Bond Index (EMBI) starting in 1993 as proxies for overall EM equity and debt markets.
Figure 6: EM Historic Debt and Equity Performance, 1989 (or Earliest Available Data) to 2020
Source: Capital IQ, Bloomberg
Over the full period, we observed that EM debt had comparable returns to equities but with lower associated risk. Therefore, we wanted to see if this risk-return profile is as attractive in crises.
We contrasted EM sovereign debt returns with 10Y US Treasury returns over 12- and 24-month holding periods after a crisis. In addition, we looked at recovery rates (i.e., when returns are positive) in each instance to understand if returns are driven by high recovery rates or by performance at the extremes.
Global Crises
Below we show return and recovery profiles for EM sovereign debt and 10Y US Treasuries during global crises (defined as periods when the S&P 500 experienced 20% drawdowns).
Figure 7: 2-Year Average Return and Recovery, US vs. EM Sovereign Debt in Global Crises, 1987–2020
Source: Capital IQ, Global Financial Data
Once again, EM sovereign debt appears to have performed better than US treasuries in global crises historically. High EM debt returns also had lower associated risk historically. This is directionally aligned with the performance of EM equities after global crises. However, EM sovereign debt generally does not outperform EM equities in idiosyncratic crises.
Idiosyncratic Crises
In computing average debt returns, we applied the same logic as to computing average equity returns during idiosyncratic crises. Below we show average return and recovery profiles for EM sovereign debt and 10Y US Treasuries during idiosyncratic crises.
Figure 8: 2-Year Average Return and Recovery, US vs. EM Sovereign Debt in Idiosyncratic EM Crises, 1987–2020
Source: Capital IQ, Global Financial Data
Historically, debt investors seem to have been much more incentivized to take advantage of EM crises when times were smooth at home. EM sovereign debt returns have been 5x higher compared to 10Y US Treasuries during idiosyncratic crises, with similar recovery rates, as depicted above. Moreover, EM sovereign debt returns during idiosyncratic crises are higher than those of any other strategy, be it debt or equity, value or not.
Comparison to Buy-and-Hold
Crisis investing did not outperform buy-and-hold in EM debt historically, as research shows. On average, crisis investing in EM debt over 24 months captured ~40% of the buy-and-hold returns and outperformed in only 21% of countries, including Brazil, Russia, and Turkey (See Appendix Figure 11).
Conclusion
A buy-and-hold strategy for EM debt over the full period had comparable returns to EM equity, but with lower volatility. This low-risk, high-return profile has also been true during EM crises historically. Crisis investing in EM sovereign debt outperformed US equities in both idiosyncratic and global crises, with similarly attractive recovery rates. At the same time, crisis investing in EM sovereign debt outperformed investing in EM equities in idiosyncratic crises, but not in global ones.
Moreover, when we contrasted the return and recovery profiles of equity and debt in emerging markets to those in developed markets, we found that EM sovereign debt is potentially more attractive relative to EM equity. Despite similar recovery rates between in two markets, developed-market debt returns in crises were 70% below equity returns, while in emerging markets, debt returns were only 30% below equity returns (See Appendix Figure 12).