While the year has started off with a bang for U.S. equities, other stock markets have posted less impressive performance. The United States is outperforming not only other developed markets -- with the exception of Japan -- but also emerging markets.
Part of emerging markets' underperformance is due to idiosyncratic factors -- like steps to curb the housing market in China. Another reason for the disappointing emerging market returns: Unlike the United States, most emerging market countries have simply not witnessed massive flows into their stock markets.
While large retail flows into U.S. equity funds may support U.S. outperformance in the near term, longer-term investors may want to give emerging market stocks another look. Here's why:
- EM currently trades at a big discount to DM. Emerging market (EM) equities are trading at 1.5x book value, while developed markets (DM) are trading at 1.8x. The United States is trading at 2.15x. On a price-to-earnings (P/E) basis, emerging markets are still trading for a bit more than 12x trailing earnings, a 30% discount to developed markets. Some valuation discount is justified given higher profitability in the developed world, but the current valuation discrepancy looks excessive.
- EM relative fundamentals still look sound. While few countries, whether emerging or developed markets, will set growth records in 2013, on a relative basis, I still expect emerging markets to grow much faster than developed ones. In addition, unlike in 2010 when faster emerging market growth came with an unhealthy dose of inflation, with a few notable exceptions like India, inflation is within the target zone of most emerging market central banks. Finally, the majority of the emerging market countries have much less "fiscal baggage" than their developed market counterparts. For developed countries, gross government debt is well above 100% of gross domestic product; in emerging markets, the ratio is just 34%.
- EM currencies generally look cheap. For investors in emerging market equities, returns will not only be a function of the equity markets, but also of the relative performance of the local currency against the dollar. With the exception of Brazil, most emerging market currencies appear undervalued relative to the dollar. If that gap closes over time, this will be a source of incremental return.
While I do like emerging markets, investors should be cognizant of the risks associated with the asset class. The biggest one is simply volatility. While the volatility of emerging market stocks and bonds is converging with that of developed markets, emerging markets are still, for now, more volatile. Over the past year, the MSCI World developed market index has had a volatility of around 13%, vs. 19% for the comparable emerging markets index. In other words, if markets head south, emerging markets are likely to feel the pain.
Also, while the growth story for emerging markets is still intact, further improvements will be dependent on continued structural reforms. In China, this means liberalizing the financial sector, while India and Brazil need more infrastructure and less red tape.
Despite these risks, for investors with a three- to five-year horizon, the current discount in emerging market stocks makes emerging markets one of the few asset classes to appear genuinely cheap. Among specific emerging market countries, I continue to like China, Brazil, and Russia and for investors seeking a less volatile strategy, I like the iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV).
Disclaimer: 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. Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets. The minimum volatility fund(s) 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.