After three losing years, emerging markets finally put in a positive performance in 2016 and have blown past the Standard & Poor’s 500 index so far this year.
One of the major emerging market exchange-traded funds, iShares MSCI Emerging Markets ETF (ticker: EEM), is up 17.65 percent for the year, versus 7.62 percent for the SPDR S&P 500 ETF Trust ( SPY).
[See: 7 ETFs for a Solid Portfolio Defense.]
That strength has attracted attention, with market watchers debating whether this is the beginning of another multi-year bull market, like the one emerging market stocks enjoyed in the 2000s, or simply a rebound from depressed levels.
Although a number of analysts and portfolio managers think enough has changed to warrant investors’ return to emerging markets, skeptics remain.
Strong tailwinds. Daniel Homan, investment analyst at Envestnet PMC in Denver, sees several key improvements in the sector. Stable commodity prices, particularly for crude oil, benefit emerging market countries because many are commodity producers and exporters. What’s more, several countries are shifting their economies away from commodity exports or state-owned enterprises toward services that cater to their own growing middle class.
China, the world’s biggest emerging market, is helping to lead the positive economic outlook. The country’s gross domestic product slowed to about 6 percent growth, from about 10 percent in its heyday several years ago, but now appears to be picking up speed again, says Michael Binger, senior portfolio manager at Gradient Investments in Arden Hills, Minnesota.
Corporate earnings growth for many emerging market companies also is rebounding.
“Return on equity in emerging markets has recently overtaken developed markets after trailing for several years. [Emerging market] companies have been focused on cutting costs and more efficiently using capital,” Homan says.
Compared to the U.S., where stock indices trade at all-time highs, emerging market companies are looking like a good deal. “They’re a great value versus U.S. equities at this point,” says Joe Heider, president of Cirrus Wealth Management in Cleveland.
The benchmark MSCI Emerging Markets Index trades around 12.5 times forward earnings as of the end of the last quarter, whereas the U.S. S&P 500 trades around 18. Developed markets on the whole trade at 17 times earnings.
“There’s a strong tailwind to emerging markets right now,” Homan says. “That’s why they’ve had such a run up in price and why investors are dipping a toe into the emerging market pool. Flows this year through March were $11 billion into mutual funds. That’s the strongest in asset flows in several years in the first quarter.”
Tread carefully. Some experts, though, caution investors not to read too much into the emerging market tea leaves.
Rupal J. Bhansali, New York-based chief investment officer and global equities portfolio manager for Ariel Investments, says people look to emerging markets because there’s a paucity of growth globally and investors believe in the region’s growth potential, which has always been the argument for investing there. But Bhansali believes people risk too much to partake in that growth, which they overestimate, and that has led to disappointment in recent years.
Investors also remember how emerging markets grew during the commodities boom, but the region’s growth between 2003 and 2007 was “a very unusual set of circumstances,” Bhansali says. At the time, China’s growing economy spiked demand for many commodities. Now, however, the markets are mired in supply challenges that have become a headwind for the region. Even though some raw materials like oil are stabilizing, she doesn’t expect another commodities boom.
[See: Oil ETFs: 8 Ways to Invest in Black Gold.]
“We just don’ t see that happening because our fundamental assessment shows that supply still exceeds demand,” Bhansali says.
She also calls the valuations “a headfake,” noting the composition of the MSCI Emerging Markets index is weighted 24 percent to financials and 25 percent to information technology, specifically hardware IT. These tend to be deeply cyclical, she says, and both are in a strong part of their economic cycle.
What to consider. Still, investors who want some emerging market exposure should understand that the sector consists of many different countries, each with their own economic challenges.
Brazil, for example, faces weak growth following a scandal with the state-owned energy company, Petrobras, which led to the impeachment and dismissal of the country’s president. Meanwhile, India is enacting pro-growth reforms, but it, too, has stumbled along the way.
Binger says his firm noticed that trading momentum has shifted from developed to emerging markets, and for investors who want to take a tactical position in their portfolio, he likes PowerShares S&P Emerging Markets Momentum Portfolio exchange-traded fund ( EEMO), an ETF his firm uses.
[See: 10 Great Ways to Buy Emerging Markets.]
“We’re looking for emerging markets not to just outperform but build on the momentum. We feel this is longer than a two- to three-month move, that it will go on for a while. Our rules-based investment process is pointing to that.”
Although Bhansali doesn’t see much opportunity in emerging markets, she’s not underweighting them either.
“As far as we’re concerned, we’re looking for select opportunities,” she says.
Two companies her firm owns are Baidu ( BIDU) and China Mobile ( CHL). Bhansali likes both because they’re not driven by the commodities cycle and they don’t have debt.
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Can Emerging Markets Continue Rallying? originally appeared on usnews.com
