Why you shouldn't overlook emerging markets

Emerging markets (EMs) have disappointed investors in recent years. Stocks have been held back by a mix of weak commodity prices, sluggish export growth, and political disruptions. The result has been a negative return of 11% for the MSCI EM index since mid-2011, lagging a 49% upswing in developed markets.

But recently, this trend has reversed. EM equities have rallied 12% this year, outpacing a 4% gain for rich nation equities.

Can this last? My team and I believe EMs will outpace more defensive developed markets, like Switzerland, and have recently increased our EM equity position to overweight in global portfolios. Five favorable factors support this shift:

#1 Steadier Chinese growth: The fortunes of China’s economy are key to the overall EM performance. With a USD 11trn GDP, China is roughly equal in size to the next 10 largest emerging markets combined. While China’s growth trajectory has slowed over the past year, the deceleration has not been abrupt. The 6.7% GDP expansion in the second quarter provided additional evidence that government stimulus is stabilizing activity. And rising consumer spending is partly offsetting weakness in the “old economy” industrial sector.

#2 Commodity goldilocks: Raw material prices are neither too hot, nor too cold. A 20% rise in the Bloomberg Commodity Spot index since the January lows has removed a headwind to economic growth and profits in commodity-exporting emerging markets, especially in Latin America. But prices have not climbed so high as to impair the outlook for Asian commodity importers.

#3 Growth gap returning: Last year, EM economies grew just three percentage points faster than developed nations, down from six percentage points in 2009. This growth advantage is likely to expand again in the coming years, particularly as the economies of Brazil and Russia stabilize after deep recessions. Purchasing managers’ indices have improved, with Asian and emerging European gauges back above the 50 level that separates expansion from contraction. Greater political stability could also help. The climate has improved recently in Brazil, with the appointment of a more market-friendly president. Tensions between Russia and the West have also eased.

#4 Profit growth in sight: Earnings per share, which have fallen by around one-third since early 2012, have started to stabilize. That has helped drive the recent EM stock rally. While valuations are now close to the average for the past decade – the trailing 12-month price-earnings ratio of the MSCI EM Index stands at 13 times – there is room for further price appreciation if profits improve as we expect.

#5 A dovish Fed: The US Federal Reserve is likely to keep rates lower for longer due to the uncertainty created by the UK referendum vote. A more dovish Fed stance than at the turn of the year has boosted emerging market currencies, up 3% against the US dollar since then. Stronger EM currencies contribute to lower inflation rates, reducing the need for growth-suppressing interest rate rises.

Of course, there are risks to monitor. A lasting rally will require the stabilization of earnings to turn into a full rebound. And the failed coup in Turkey is a reminder that political risk can stoke market volatility. But on balance, we believe the outlook for emerging market stocks is bright.

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