Since the Fed first signaled its intent to taper last May, emerging market assets – both stocks and bonds – have spent most of the last five months under pressure, although they have rebounded in recent weeks. Despite September’s rally, some market watchers are declaring the popping of a long-term EM bubble.
As I write in my new Market Perspective piece, “The Case for Emerging Markets,” even with EM’s underperformance year-to-date, there are four reasons why investors underweight or not exposed to this asset class may want to consider gaining some EM exposure for the long term.
1. EM fundamentals have improved over the long term. EM fundamentals have improved considerably in the 15 years since the late 1990s financial crisis. In general, emerging markets enjoy relatively low levels of dollar denominated debt in contrast to 1997 to 1998. EM financial sectors are more robust than in the past and EM nations have improved access to capital markets. In addition, many of the largest ones, particularly China, are sitting on extensive foreign currency reserves. Overall, EM countries now have better capacity to absorb external shocks, something that was evident when they withstood the worst part of the 2008-2009 crisis relatively well.
2. Valuations suggest a good long-term entry point. Today, most traditional valuation metrics— price-to-earnings, price-to-book and price-to-cash flow—suggest that EM equities are cheap relative to both their history and developed markets. Using a price-to-earnings measurement, EM equities were recently trading at nearly a 35% discount to developed markets, a significant discount even by historical standards, and similar discounts in the past have produced strong relative returns over the longer term.
In addition, today’s valuations suggest a good deal more pessimism about the asset class than is warranted by the fundamentals. In other words, EM equities look cheap even after adjusting for EM countries’ slower growth and lower profitability as compared with developed markets.
3. Diversification (albeit with more volatility). Part of the case for EM is based on risk. While EM stocks have become more correlated with those of the developed world, they are still diversifying over the long term. In other words, while EM stocks are volatile, for certain portfolios, emerging markets can potentially help risk-adjusted returns through diversification.
4. Most EM currencies still look inexpensive relative to the dollar, even after this week’s rally in emerging market currencies. If anything, a more accommodative monetary policy and a softer dollar are supportive of emerging markets.
To be sure, there are headwinds facing EM stocks. Amid the volatility we could see ahead as the US budget debate heats up and the recent drawdown in sovereign foreign exchange reserves, EM countries are facing increasing pressure to raise local rates, as evident in Friday’s news out of India. Higher rates would be a headwind to nascent EM growth stabilization. As such, I’m advocating that implementation in the EM space should be largely driven by investor risk tolerance. Investors looking to gain some EM exposure while seeking less volatility may want to consider minimum volatility as well as long-short funds. But the good news is that the Fed’s reluctance to taper does remove a short-term headwind to EM equities, raising their near-term prospects.
Source: Bloomberg, Market Perspectives, Investment Directions
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. Diversification may not protect against market risk or loss of principal. . Minimum Volatility Index Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful. Compared to a traditional long-only portfolio, the potential for volatility (compared to the market and the fund’s benchmark) is anticipated to be greater for long-short funds given their additional long exposure along with the short exposure. Long-short funds may actively engage in short-selling, which entails special risks. If a fund makes short sales in securities that increase in value, the fund will lose value. Any loss on short positions may or may not be offset by investing short-sale proceeds in other investments.