Emerging market stocks have started to outperform developed market equities. We believe that investors should maintain a long-term overweight in EM stocks, but need to be prepared for significant volatility and focus on being selective in their country and company selection.

Last summer emerging markets, both stocks and bonds, had the distinction of being the most unloved asset class. Since then, markets have calmed down. Emerging market stocks are up around 9% since last summer, and have narrowly outperformed their developed market counterparts. Has the luster returned for EM? As is often the case with EM, the story is nuanced. Here are four things to keep in mind:

1) Headwinds remain. These include slowing growth in China and India, inflation in Turkey and India, and the looming uncertainty of how these markets will perform once the Fed finally begins to taper.

2) Be prepared for volatility. Despite the outperformance, as my colleague Dodd Kittsley notes, EM countries are still struggling with outflows. This is not surprising as this asset class remains highly volatile. EM stocks are still more volatile than DM and add considerable risk to a portfolio. Volatility is down from the summer, but remains elevated relative to developed markets. For example, the 3-month trailing volatility on the iShares Emerging Market ETF (EEM) is 19%, compared to 9-10% for developed markets. Practically, this means that any overweight needs to be constrained in all but the most aggressive portfolios.

3) Pay attention to corporate governance. Specifically, investors should remain cognizant of how EM companies are deploying their cash-flow. One of the key criticisms on EM companies is that while the economies may grow faster, probably much faster, economic growth has not always translated into shareholder value. This is because too many EM companies burn through cash flow. If investors are to make money in emerging markets, they need to be sure that economic growth eventually translates into corporate profits and free cash flow

4) Invest for the long term. Despite the caveats above, EM equities do represent a long-term opportunity for more aggressive investors. The main argument in favor of emerging markets – relative valuation – still holds, despite the outperformance. EM stocks trade at a significant discount based on both price-to-book (25%) and price-to-earnings (35%). At least historically, discounts of this magnitude have been associated with positive relative performance over the next year or longer.

In addition, while we don’t expect a boom in any of the larger EM economies, we do expect stability in 2014. And there are at least some positive catalysts on the horizon. Most notably, following a lukewarm initial reaction, investors are now starting to warm to the fact that China appears serious about reforming its economy.

In terms of specifics, we continue to see opportunities in Chinese equities. Despite the recent rally, valuations remain low and growth, while slower, is still better than any other large country. As I’ve advocated before, broaden the definition of EM to include a small allocation to frontier markets. Despite the travails of EM, the frontier markets are up over 20% year to date.

Finally, investors may also want to consider domestic companies levered to China and the rest of Asia, where spending continues to grow. One recent example, in the last quarter Tiffany reported a 27% jump in Asia-Pacific sales.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog.

Source: Bloomberg


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