Emerging Markets: Reason To Hope

Driven partly by hopes Chinese officials will implement some additional and fairly significant reflation projects, emerging markets stocks (EEM) have performed well recently relative to the S&P 500 (SPY). From The New York Times:

China's leaders are issuing increasingly clear signals that they plan another round of economic stimulus programs, as evidence accumulates that the economy is slowing more than expected this year. A government-affiliated survey released Thursday of purchasing managers' sentiment in nonmanufacturing sectors like construction, computer software and aviation showed a fairly sharp drop in March.

Emerging Markets/Yellen Reflation Trade Facing Big Test

Chinese officials, the European Central Bank, and the Federal Reserve are all concerned about low inflation and tepid economic growth. Have investors shared the same concerns in recent months? The chart below, showing the performance of emerging markets (EEM) relative to the S&P 500 (SPY), says "yes, investors are also concerned about tepid growth and low inflation." EEM has failed to clear resistance at similar points in the past (see red arrows below). Based on what happens near the purple arrow below, we should learn something about global stocks and the global economy.

Wednesday's Announcement

During Thursday's trading session, EEM was down over 1.0%, while the S&P 500's decline was only 0.18%. The underperformance could possibly have been sparked by disappointment in the relatively tame announcement from Chinese officials Wednesday night. From The Wall Street Journal:

China's latest economic stimulus can be seen as more of a statement of priorities than a powerful effort to jump-start growth. The message: growth trumps concerns about a credit bubble. On Wednesday night, the government's top decision-making body, the State Council, announced a spending package consisting of new railways and subways, low-income housing and tax breaks for small business.

Downtrend Hard To Buck Without China

The weekly chart showing an area of possible resistance for EEM also shows a clear and established bearish trend for emerging markets stocks relative to the S&P 500, which is a reflection of how investors feel about emerging markets and more specifically about the Chinese economy. Since China (FXI) makes up almost 20% of EEM, it would be much easier for EEM to clear resistance if China would lend a hand.

China Trying To Complete Shift

China is being held back by many factors, including Fed tapering and a slow transition from a credit-goosed economy to a more sustainable and slower growth model. From Bloomberg:

Emerging markets, increasingly dependent on China for their own growth, may suffer as the world's second-largest economy decelerates, the International Monetary Fund said. "China's transition into a slower, if more sustainable, pace of growth will also reduce growth in many other emerging market economies, at least temporarily," the IMF said in part of its latest World Economic Outlook report released today. The market turbulence in mid-2013 as the U.S. Federal Reserve weighed the tapering of its bond-buying program also showed that emerging markets will suffer if access to capital abroad is harder to obtain, the IMF said. Growth forecasts in the report are scheduled to be released April 8.

Why U.S. Stock Investors Should Care

Just as it is a positive reflection of the U.S. economy when small cap (IWM) stocks outperform the S&P 500, when emerging markets provide global leadership it speaks to a more confident stance relative to economies with higher growth potential. For example, during the last phase of the Greenspan-induced 2002-2007 bull market in U.S. stocks, EEM was a market leader, rather than the laggard it is today.

Investment Implications - EEM As Global Signal

Our market model has not seen enough yet to allocate capital into the emerging markets space, but it has seen enough that we are open to doing so if EEM can clear some additional hurdles, including the resistance area covered earlier. Even if we do not take a position in EEM, we prefer to see it get over the hump since it makes it easier to invest in all stocks from a confidence perspective. For now, recent "flat momentum" is trying to resolve itself to the upside, but as we often mention in our weekly videos weekly charts can change significantly intraweek. Therefore, we are content holding diversified stock positions, including the S&P 500 (SPY) and an equally-weighted S&P 500 ETF (RSP). Our cash buffer is in place to offset the market's recent indecisive behavior. We reduced that buffer earlier in the week and would most likely do so again before the week is out if the bulls can hold on to their recent gains.