Being down on emerging markets is now conventional wisdom, fueled by a host of bearish concerns ranging from a strong dollar, to slowing economic growth in China, Japan and Europe, to the mixed impact of falling oil prices. Throw in nagging geopolitical fears of instability, and many investors simply prefer to stay at home.
But are emerging market bears doing their homework? More importantly: Does being underweight in emerging markets run the future risk of investors being caught on
the sidelines? Historically, collapsing flows and valuations in markets have reversed dramatically. For every March 6, 2009—when the DJIA hit a 12-year low after losing over half of its value since October 2007—there is a March 9, when the Dow reversed course and proceeded to gain 20 percent over the next three weeks. No one could know then that this would be the turning point of the Global Financial Crisis. While we know that past performance is no indicator of future results, emerging markets stocks have typically bounced back big—and rapidly—after multiple down years [see infographic].The MSCI EM Index has had three consecutive down years just once in the past quarter century, from 1999 to 2002.
So is now the time to rethink emerging markets? One key element investors appear to be ignoring, and current stock valuations are not reflecting, is the widely accepted view that much of the world’s future economic growth is expected to come from emerging markets. Although it is theoretically possible that a secular shift away from emerging markets is underway, that ignores the economic, demographic and societal fundamentals in those markets today. A more likely scenario, backed by recent history, is that these markets, as well as the global economy, will rebound, and that emerging markets in aggregate will once again outperform developed ones.
A Valuations Disconnect
The other critical consideration is that these emerging market economic fundamentals are not reflected in equity valuations. The MSCI Emerging Markets Index has a P/E ratio of 12—a figure that looks relatively inexpensive when compared to the U.S. stock market ratio of 18 and the index’s long-term average multiple of 14.6. This could present an attractive entry point for under-allocated investors who have determined that emerging markets are a suitable allocation—and there appears to be no shortage of those.
According to data from EPFR Global, an information company that provides fund flow data to financial institutions worldwide, institutional investors are, on average, under-allocated to emerging markets when using the ACWI index as a measure. This index, which offers exposure to a broad range of both developed and emerging markets, gives EMs a 13 percent weighting, while investors have reduced their new allocations to EM equities by -10.1% over the last 2 years.
Considering Next Steps
No one likes to try to catch a falling knife, and trying to time the market is a fool’s game. However, those investors with faith in the economies of emerging markets and willing to absorb the risks can seek more EM exposure in an effort to be well positioned should the market eventually turn. “Given the recent selloff, now may be a good time to consider rebuilding your exposure in emerging markets, says Heidi Richardson, Global Investment Strategist at BlackRock.” After a year of under-allocation in many portfolios, our contrarian view is that we are at a favorable time to consider re-entering emerging market equities. Compelling valuations – both relatively and historically - and positive growth momentum give us confidence in the entry point,”
For the investor who places a premium on economic fundamentals and challenging conventional wisdom, a market based on fear and rich with under-valued equity could offer a terrific opportunity. But you have to be invested to reap the potential benefit.
*Source of information in this story is Bloomberg, as of 1/2015, unless otherwise noted.
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