Japanese Lanterns

While most equity markets have rallied year-to-date, emerging markets have largely sat out the party.

Year-to-date, developed markets are up roughly 10%, and US and Japanese stocks are doing far better. At the same time, emerging markets are down by around 4%. Their underperformance can be blamed on disappointing growth figures and the bias of many investors toward markets that feel the safest (i.e. the United States).

In light of the recent poor performance, many investors are asking me whether they should be abandoning emerging markets in favor of bets closer to home. My answer: clearly “no” for three new reasons.

1.)    Emerging market countries are still growing much faster than developed countries. Since the start of the financial crisis, emerging market countries together have posted gross domestic product growth of 15%, while developed markets have only grown 4%. And emerging markets’ faster growth is likely to continue. China is still growing at around 7.5% and many smaller emerging markets countries are posting similarly fast rates. With emerging market countries now a large part of the global economy, not owning them may mean missing out on a good part of global growth.

2.)    Growth expectations for emerging market countries are becoming more modest. Emerging markets’ recent underperformance has a lot to do with the fact that the countries’ growth rates have generally slowed more than investors expected. In other words, it’s not the absolute level of growth that has been the problem; it’s the level relative to expectations. Looking forward, more modest growth expectations should make it easier for emerging market growth to surprise to the upside.

3.)    Emerging market valuations look attractive. Emerging market fundamentals have certainly deteriorated lately. However, valuations have also fallen, both on an absolute basis and relative to developed markets. In addition, the bad news regarding growth already appears reflected in prices.

While I believe investors should remain invested in emerging markets, I’m not advocating a straight allocation to basic emerging market stock funds. Instead, I prefer three alternatives:

1.)    Minimum volatility funds, which are designed to help smooth out volatility, such as the iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV).

2.)    Funds representing regions or countries (I still like China)

3.)    Interpreting “emerging markets” to also include frontier markets. While a traditional emerging market benchmark is down year-to-date, frontier, or “pre-emerging” markets, have been performing well. Frontier markets are accessible through the iShares MSCI Frontier 100 ETF (FM).

Source: Bloomberg

The author is long both EEMV and FM

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

 

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets. Securities focusing on a single country may be subject to higher volatility.