Emerging markets (EM) peaked on January 26, 2018, and have underperformed the S&P 500 by about 15% since then. A combination of factors contributed to the recent weakness. The Fed began winding down its balance sheet and continued its hawkish stance, encouraged by the improving US economy and expected benefits of the US tax cut. The fear of a prolonged trade war started by Trump’s tariffs and threat of more to come has also weighed on investor sentiment toward emerging markets and risk in general. And no emerging market sell-off would be complete without a strong rally in the US dollar.

The bull case is that the magnitude of the EM price decline suggests that the sell-off is probably close to the end. This argument makes sense if you believe that the current sell-off is not a reversal of the previous medium-term trend. Global growth shows no sign of dropping off after several years of sub-par growth following the 2008 crisis. Emerging markets bottomed relative to the SPX in 2016 as well. Of the emerging markets, India (INDA) probably has the best fundamental and technical backdrop, and is the country least exposed to a trade war (least reliant on exports).

The bear case is that the trade war intensifies, which is also a possibility given the geopolitical uncertainty. Also further USD strength would create pressure on liquidity and support a negative feedback loop.

We believe the bull case is more compelling at this point. Below are some charts to provide a bit of context.

When EEM / SPY is in an uptrend, a typical sell-off is 15-20%, which happened in 2004, 2006, and 2016. The current underperformance is around 15% since the peak in January which suggests that the current sell-off is close to finished. An important assumption in this type of analysis is that we’re not entering a prolonged bear market similar to 2008 and 2011-2016.

The reasons underlying previous emerging markets sell-offs are always different, but most sell-offs are usually accompanied by a strengthening USD, as was the case in the current episode.
Source: Koyfin.  Click here to pull up this chart in Koyfin.com

The sell-off in emerging markets doesn’t match the strong performance of commodities, particularly oil, which is typically correlated with EM since many EM economies are producers/exporters of commodities.

Source: Koyfin.  Click here to pull up this chart in Koyfin.com

The countries that are most exposed to trade tensions, such as China (FXI) & Brazil (EWZ), and/or have a high current account deficit, such as South Africa (EWA), have underperformed the most since January. The countries with the lowest reliance on trade/exports, India (INDA) & Mexico (EWW) or have a strong secular theme, Taiwan (EWT) with tech exposure, are outperforming.
Source: Koyfin. Click here to see this chart in Koyfin

The fundamentals of emerging markets remain solid. GDP growth (Y/Y) has remained steady in the biggest emerging economies (China and India), and is recovering in Brazil and Russia. The long-term driver of growth for these countries remains in place: high population growth, high productivity, and generally low leverage.  
Source: Koyfin. Click here to pull up this chart on Koyfin.com

How will we know if the EM sell-off will gain steam and turn into a prolonged downturn? The news and fundamental developments matter a lot. But more interesting is that many of the EM ETFs are right near very strong support levels. A break below these levels would suggest this is more than a typical sell-off.

Emerging markets ETF (EEM) is sitting at a very important support, which served as the previous resistance for 10 years!

Source: Koyfin. Click here to pull up this chart on Koyfin.com

South Korea (EWY) is one of the most cyclically sensitive emerging markets and broke out of 10-year resistance in 2017. The ETF is now $3, or 5%, above a major support level. This is a good candidate to put on the shopping list.
Source: Koyfin. Click here to pull up this chart on Koyfin.com

India (INDA) has powerful long term secular trends working in its favor including attractive demographics, population growth, reformist government policies and low reliance on exports. The ETF is down about 13% from the peak and is trading near its recent support. A bearish argument can be made that there is a potential head & shoulders pattern forming. However, a head & shoulders pattern would need to be confirmed by a break below the neckline (around $32/share).

Source: Koyfin. Click here to pull up this chart on Koyfin.com