Most emerging markets have been out of favor in recent years while U.S. equities have shown impressive gains, creating a divergence between developed and emerging markets. For Rob Arnott, that spells opportunity.
Arnott, chairman and CEO of Research Affiliates, a Newport Beach, California, firm that specializes in smart beta strategies, says a number of developments have led investors to pull back from emerging markets. “You have Putin on the march in Eastern Europe,” he says of Russian President Vladimir Putin. “You have the shadow banking system in China looking distinctly fragile. You have elections across Latin America shifting step by step in a more socialist direction. You have blood in the streets — literally, not figuratively — across the Middle East.” And to top matters off, Saudi Arabia sent falling oil prices plunging in November when it refused to curtail production.
The recent sell-off may offer a rare opportunity for courageous investors to increase exposure to emerging markets at deep discounts, says Arnott. Although investors can’t know when the bear market in EM equities will end, emerging markets are “priced to provide some pretty remarkable forward rates of return,” he contends.
David Iben, chief investment officer and lead portfolio manager at Kopernik Global Investors in Tampa, Florida, shares Arnott’s optimism. He believes investor attitudes toward emerging markets are prone to excessive swings.
“I think the markets made a mistake by loving resources in emerging markets four or five years ago,” says Iben. “I think they are making a colossal mistake right now to price these things at a huge discount to the U.S., when these countries will almost assuredly grow faster than us over the next ten years.” He points out that the MSCI Emerging Markets index is trading at roughly 12 times earnings of the companies in the index, whereas the U.S. stock market trades at some 18 times earnings. “The U.S. is 50 percent more expensive, although the U.S. will grow slower over the long term,” Iben says.
Investors looking to take advantage of the valuation gap between those markets must beware of “the risk of value traps,” cautions Allan Conway, head of emerging-markets equities at Schroders in London. Stocks that look cheap by price-to-earnings ratios but may fall even lower still, he warns. Yet even Conway sees signs that the bear market in EM equities is coming to an end. “The last three or four years, emerging markets have underperformed quite significantly,” he says. But as 2014 draws to a close, he adds, “even with the massive volatility in the last month or so, emerging markets year-to-date are slightly outperforming developed Europe and Japan.”
In addition, much of the massive divergence between emerging and developed markets in recent years does not correspond to a difference in fundamentals. “If you look at the earnings growth of the emerging relative to the developed world, there is very little difference,” says Conway. Consider the case of 2013, when the Standard & Poor’s 500 index rose 33 percent while the MSCI Emerging Markets index declined 3 percent, yet earnings grew 6 percent in emerging markets that year, almost as much as the 7 percent growth in U.S. earnings. “Where you’re left today is, the developed markets tend to look more expensive, the emerging — cheap,” he notes.
The rising dollar has made emerging-markets performance look worse than the underlying fundamentals suggest, according to Arjun Jayaraman, portfolio manager of the Causeway Emerging Markets Fund in Los Angeles. Emerging markets this year have been flat to slightly higher in local currency terms, he says. The weakness of the MSCI Emerging Markets index, which was down 4.39 percent this year as of December 29, is mainly a by-product of the strong dollar because that index is denominated in the U.S. currency. The MSCI Emerging Markets index has actually outperformed the MSCI EAFE index, covering Europe, Australasia and the Far East, which was down 6.38 percent over the same period.
In a contagion effect reminiscent of 1998, many emerging countries that are not oil and gas producers have suffered big equity price declines. “They should benefit from lower oil prices,” says Jayaraman, especially oil importers China, India, South Korea and Taiwan. Although he sees headwinds from the Federal Reserve, which is expected to begin gradually raising interest rates in 2015, he believes lower oil prices will likely offset the impact of higher U.S. rates.
Causeway is overweight in its allocations to India, giving it a weight of 11 percent, compared with India’s 7 percent weighting in the MSCI EM index. That’s not surprising, given that Indian equities are up 26 percent this year in U.S. dollars. “India is one of the few countries where growth can improve,” says Jayaraman. “In China, in the rest of Asia and in Latin America, all the growth rates are falling.” Causeway expects emerging-markets economies to grow by 4.5 percent in 2015.
A lot of emerging-markets economies around the world “are between a rock and a hard place,” says John Krey, international cross-asset investment analyst at S&P Capital IQ in New York. For example, in Brazil inflation is up, deficits are widening, and growth is slowing, “not the optimal combination of trends for the central bank to work with.”
S&P Capital IQ recommends that investors overweight allocations to China, Taiwan, the Philippines and South Korea. In Latin America, Krey recommends increasing exposure to Mexico and Colombia while reducing it to Venezuela, Ecuador and Argentina. He also recommends higher exposure to Poland, Hungary and Israel, whereas he prefers reducing exposure to Turkey, Russia and South Africa.
The bottom line is that emerging markets are offering bargains to investors who have the courage to comb through the possibilities and find bargains with good growth potential. “As a contrarian, I like that a lot, but it goes hand in hand with a clear need to be patient,” says Arnott. Prices can go lower from here, he warns. “That’s why it’s important to not overcommit to a cheap market, because it can get cheaper. You can ramp up exposure when it is hammered to lower prices.”
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