Why Emerging Market Equities Are a Good Investment

The race to the bottom has been long and painful. Central banks have been fighting against each other to deflate their currencies faster than the rest of the world, hoping to export goods at deflated prices. Nine years have passed since the Great Recession, but little has changed in economic policy. The race to the bottom is alive and well in many parts of the global economy. Although that may have begun to change. The United States has raised interest rates twice over the past 15 months and anticipates raising them three times during 2017. Speculation regarding the Czech Republic is that it will abandon its currency ceiling and allow the koruna to appreciate. Is this the new race to the top? We don’t think so, but we do believe the dollar has begun to retreat. In the following paragraphs we will discuss the potential themes that we believe make emerging market equities attractive today.

The Trump administration has signaled that they would prefer a deflated green-back. Additionally, the recent rebound of emerging market equities and their uncharacteristically low volatility, could potentially make carry trades in developing currencies attractive. The current market environment allows investors to borrow at historically low rates in developed-country currency and to buy emerging market government debt in local currencies, which yield roughly 3% higher than U.S. Treasuries. It appears that this trade has already begun, but it is certainly not crowded at the moment. What impact will this have on emerging market currencies should the trade become more crowded?

Emerging market equities were severely hit June 2014 through January 2016 due to falling commodity prices and the rapidly rising U.S. dollar. The MSCI EM Index was down 28% during this 19-month period. A rising dollar and falling commodity prices represent the worst type of environment for emerging market equities. George Soros often discusses "reflexivity," which is a term that he uses to iterate that investors often oversell bad news and overbuy good news. By January 2016 investors had oversold the news. They have yet to overbuy the fact that the dollar is now retreating and commodities have entered into a new multi-year bull market. (For related reading, see: Overbought or Oversold? Use the Relative Strength Index to Find out.)

Emerging market valuations remain extremely low and their macroeconomic characteristics are as strong as they have been in over a decade. It’s time to make money buying emerging market equities. Let’s begin by looking at valuations. The S&P 500 is currently trading at valuations that are more than 50% higher than their historical average. By contrast, emerging market valuations in Asia are trading at 30% less than historical norms. Emerging markets, as a whole, are trading at nearly a 20% discount to historical valuations. Emerging market equities were thrown out with the bath water a year ago, and they have a long way to go before becoming an overbought asset class. (For related reading, see: Equity Valuation in Emerging Markets.)

Afraid of global debt levels? No need if you are buying emerging market equities. Years ago economists would say that should a country’s debt-to-GDP ratio surpass 100%, the downward spiral to insolvency or debt re-structuring was inevitable. Today, the United States of America sits at 110% of debt-to-GDP, and their developed market counterparts, the Eurozone, stand at nearly 130%. Scary yes, but not if you are buying equities in fiscally responsible emerging market countries. China sits at roughly 10% debt-to-GDP and India, Brazil, the Philippines, Indonesia, Korea, Taiwan, Thailand, Russia, Peru, Mexico and Chile all register less than 50% of debt-to-GDP. 

How to make money? Obviously, simply buying an ETF that represents the entire universe of emerging market equities is one avenue. Another play would be to over-weight those countries that have the potential to outperform, or to buy individual equities as an aggressive way to gain exposure to emerging market equities.

(For more from this author, see: How Investors Can Prepare for a Bond Bear Market.)