After a hot January, emerging market stocks are now again underperforming their U.S. peers.
The iShares MSCI Emerging Markets exchange-traded fund (EEM) is up 9% year-to-date, against 12% for the S&P 500 (.SPX).
But conditions remain ripe for a further rally in emerging markets, investors say. The macro risks that have been frightening investors—from a Chinese hard landing to an escalating Washington-Beijing trade war—seem to be lessening. The U.S. economy is slowing to a “Goldilocks” pace from the standpoint of emerging markets: vigorous enough to support global growth, but measured enough to keep the Federal Reserve dovish. And valuations remain cheap by historical standards.
“Our central position is for positive outcomes on the big issues,” says Jorge Mariscal, chief investment officer for emerging markets at UBS Global Wealth Management. “We are overweight global emerging market equities.”
China, whose economic growth rate has slowed to about 6.5% from double digits over the past decade, is the question mark at the heart of emerging markets. It accounts for a third of the global index itself and sets the stage for other big players, from Brazil to Taiwan. But investors are giving Beijing’s latest stimulus moves, and longer-term shift from export reliance to consumption, the benefit of the doubt at current prices.
“China recovery is the most vulnerable part of the EM story, but the balance of data is going in the right direction,” says David Hauner, an emerging markets strategist with Bank of America Merrill Lynch.
The U.S. environment is clearly more favorable toward emerging markets now than it was in 2018, and not only because President Donald Trump is talking up trade peace. Gross domestic product growth should cool closer to 2% from near 3% as the steroids from Washington’s late-2017 tax cut dissipate. That could put further Fed rate increases, which vacuum capital from the rest of the world, on hold, without calamitously weakening global demand. “Around 2% U.S. growth is perfect for EM,” Hauner says.
With the Fed on pause, the dollar should eventually fall from near-historic highs on a trade-weighted basis, translating to strength in other currencies and their assets. “Our view is to buy when FX is cheap,” says Justin Thomson, chief investment officer for international equity at T. Rowe Price. “You can make a lot of money in a short space of time when that dollar tear ends.”
The best profit may be found among countries most beaten up by last year’s flight from emerging markets, like Mexico, Turkey, South Africa, and Russia, says Aaron Hurd, senior currency portfolio manager at State Street Global Advisors. “The market tends to overreact a bit in countries with specific issues,” he says. “We’re happy to go collect some of that excess risk.”
The political forecast elsewhere is brightening, too. Investors are expecting that Jair Bolsonaro’s government will push a critical pension reform through Brazil’s fractious congress sometime this year, and that Prime Minister Narendra Modi of India will retain power in elections starting next month, keeping the No. 4 emerging market on its world-beating growth path.
All these green shoots are sprouting in the soil of attractive valuations. Emerging market stocks are trading at a 25% discount to global indexes, compared with a 16% average since 2001, based on a blend of price/earnings and price-to-book value, says Kostya Etus, senior portfolio manager at ETF advisor CLS Investments. Plenty could go wrong with the sanguine picture on emerging markets, of course. But staying in the game is likely worth it.