Since the Fed first signaled its intent to taper last May, emerging market assets – both stocks and bonds – have spent most of the last five months under pressure, although they have rebounded in recent weeks. Despite September’s rally, some market watchers are declaring the popping of a long-term EM bubble.
As I write in my new Market Perspective piece, “The Case for Emerging Markets,” even with EM’s underperformance year-to-date, there are four reasons why investors underweight or not exposed to this asset class may want to consider gaining some EM exposure for the long term.
1. EM fundamentals have improved over the long term. EM fundamentals have improved considerably in the 15 years since the late 1990s financial crisis. In general, emerging markets enjoy relatively low levels of dollar denominated debt in contrast to 1997 to 1998. EM financial sectors are more robust than in the past and EM nations have improved access to capital markets. In addition, many of the largest ones, particularly China, are sitting on extensive foreign currency reserves. Overall, EM countries now have better capacity to absorb external shocks, something that was evident when they withstood the worst part of the 2008-2009 crisis relatively well.
2. Valuations suggest a good long-term entry point. Today, most traditional valuation metrics— price-to-earnings, price-to-book and price-to-cash flow—suggest that EM equities are cheap relative to both their history and developed markets. Using a price-to-earnings measurement, EM equities were recently trading at nearly a 35% discount to developed markets, a significant discount even by historical standards, and similar discounts in the past have produced strong relative returns over the longer term.
In addition, today’s valuations suggest a good deal more pessimism about the asset class than is warranted by the fundamentals. In other words, EM equities look cheap even after adjusting for EM countries’ slower growth and lower profitability as compared with developed markets.