Is It Too Late to Catch the Emerging-Market Rally?
After a strong stretch for emerging markets so far in 2016, some investors wonder whether the rally still has legs. Although stock valuations have risen, we think signs point to yes.
Year to date through September, the MSCI Emerging Markets Index returned 16.4%. That showing outpaced the 6.1% gain of the MSCI World Index and the 7.8% gain of the S&P 500 Index. Although there are risks, we believe the emerging-market (EM) rally could continue with improving opportunities, driven in part by Chinese monetary stimulus, and supported by stabilization in commodity prices, continued growth in the US and firming exports from EM economies.
What are some of the risks on the horizon? They include another possible US Federal Reserve rate hike, a presidential election with global trade as a major issue, and simmering geopolitical tensions involving Russia and China.
It’s understandable that some investors might want to take their recent gains and go home, while others might be reluctant to invest new money. But we see good reasons to stay committed—and we believe certain EM investments have considerable room to run.
In January, we said that EM equities and debt would generate strong returns based on attractive valuations, still-intact fundamentals and positive technical factors. Even after the rally, EM equities haven’t caught up with developed-world equities after five tough years (Display, left). And while the price-to-earnings discount of EM stocks relative to developed-market stocks has narrowed, the valuation gap of 23% is still sizable (Display, right).
With higher valuations, it’s important to be selective, to control for risks and to avoid markets where valuations are stretched. These markets tend to be more volatile, so investors have to ask whether the quest for higher returns is worth the extra risk. Actively searching across asset classes offers the flexibility to stay nimble and manage risks.
BRAZIL AND INDONESIA LEAD EM DEBT OPPORTUNITIES
As EM equity and debt markets have recovered, we’ve seen the opportunity shift. After last year’s 15% decline, local-currency EM bonds have become increasingly attractive. Countries like Brazil and Indonesia offer the world’s highest real interest rates as inflation pressures ease, which leaves scope for rates to fall. That could boost returns from potential price gains and lucrative coupons.
On the other hand, some EM debt markets have become crowded, pushing yields below those of comparably rated developed-market bonds. US dollar–denominated EM bonds issued by central and eastern European governments, for example, now trade at much tighter credit spreads than do similarly rated US corporate issues (Display).
CHINA’S ECONOMIC STABILIZATION BOOSTS GLOBAL STOCKS
A shift is also under way within equities. After a “safety trade” in the first half of the year sent lower-volatility stocks higher, investors are starting to find bargains in more cyclical areas. One reason: improvement in China.