- Emerging markets are up 10% since our last article on the subject, but the FED’s rate action might quickly erase the gains.
- Valuations are starting to diverge, but don’t fight the trend.
- Keep an eye on China as it is relatively undervalued and still boosts economic growth of 6.7%.
In May we discussed how emerging markets have been rediscovered but are still undervalued. Since then, the emerging markets ETF is up 10%.
Figure 1: iShares MSCI Emerging Markets ETF (EEM) since May. Source: iShares.
As emerging markets include a lot of countries and segments, in this article we are going to see which segments in emerging markets are the best investments and which hold the highest risks.
What Has Been Going On?
The central reason emerging markets have outperformed is because investors regained confidence in them and plowed more capital into them, unlike in 2015 when the story was the opposite. The fact that developed countries continue with their monetary easing increases risk appetite and forces investors to search for better returns in riskier assets such as emerging markets. This partly explains why emerging markets asset prices have been pushed higher.
Not only do stocks enjoy the benefit of global monetary easing, but so do bonds. As emerging markets have higher yields, desperate investors pursue those yields no matter the risks. But this is a common trap in which many investors have been caught in the past. Think of Argentina. This is a typical textbook situation, when yields are high and increasing, people pull their money out of emerging markets in fear that things might get worse. But when yields are falling, and it is unlikely that things will get better, people plow money into emerging markets. The emerging markets premium in comparison to U.S. junk bonds is minimal, but let’s not forget that by holding emerging market debt you are often exposed to currency risks.
Figure 2: Difference between yields on emerging markets and U.S. junk bonds. Source: Bloomberg.
Such a low premium suggest that investors should carefully assess the risks before investing in emerging markets at these low yields. But what is pushing emerging markets up is the opposite of what pushed them down in 2015, capital inflows and outflows. Since the beginning of 2016, capital inflows have been increasing.
Figure 3: Total non-resident capital inflows to emerging markets. Source: Institute of International Finance.
With increased capital inflows, asset prices are bound to go up, but not all emerging markets are enjoying the same investor confidence. China is a good example. Global funds toward China are negative as investors fear the further depreciation of the yuan and slower economic growth.
From a valuation perspective, emerging markets are still undervalued despite the recent upside. The iShares MSCI Emerging Markets ETF (EEM) has a PE ratio of 11.56 and a price-to-book value of 1.56 which is still far from the iShares S&P 500 ETF (IVV) PE ratio of 20.7 and price-to-book value of 2.88. Chinese stocks are the cheapest with a PE ratio of just 8.24 and a price-to-book value of 1.41 for the iShares MSCI China ETF (MCHI).
Figure 3: Emerging markets funds. Source: Wall Street Journal.
As our primary investment thesis back in May was that emerging markets are undervalued, the current price increase and investor unwillingness to invest in China make it the probable future winner. To know more about recent developments in China read our recent article on it here.
As global emerging markets are in an uptrend and far from fair valuations, it might be premature to completely jump exclusively into China and ignore other emerging markets. However, as valuations in other emerging markets continue to increase, creating an even larger divergence from China, it might make sense to “overweight” your portfolio toward China, since in the long term earnings are all that matter.
As a point of reference, the Brazil ETF (EWZ) PE ratio is 13.29 while the Indian ETF (INDA) PE ratio is higher at 21.15. Compared to a PE ratio of 8.24 for China. More daring investors might want to look at Russia where the situation has stabilized but still has low valuations with a PE ratio of 7.36 and a price-to-book ratio of 0.76 for the iShares Russian ETF (ERUS). We’ll discuss more about Russia in a future Investiv Daily article.
For specific investments, the “detailed holdings and analytics” document on the iShares ETFs’ page is a great resource.
When investing in emerging markets, don’t forget about risk. Drops are sudden and sharp, especially around high valuations and low yields. For example, the iShares China ETF (MCHI) is still 28.5% below its 2015 high.
Figure 4: China ETF. Source: iShares.
The moral of the story is to always look at valuations and don’t get euphoric about emerging markets. Boom and bust cycles are much more frequent than with developed markets due to lower market capitalizations that are strongly influenced by global capital flows which are fickle. We have witnessed two sharp emerging markets declines in the last 12 months—one in August 2015 and the second in January—both of which are a good reminder to not forget that volatility is on the daily menu and another downturn might be just around the corner.
The Fed poses an additional risk to emerging markets if it decides to increase rates due to the tightening U.S. labor market in order to stay ahead of the curve. Higher interest rates in the U.S. would quickly shift capital flows to the less risky U.S. from the riskier emerging markets.
Emerging market are and will stay difficult to navigate. Their volatility is based on low market capitalizations that can easily be influenced with relatively low capital flows when compared to developed markets. Therefore, a good idea is to watch them carefully and not fight the trend because emerging markets tend to move fast in various directions. In January 2016, it seemed like the end of emerging markets was near and now, just 8 months later, it seems all roses.
For investors not exposed to emerging markets, the best thing to do is to look at specific assets that have consistent cash flows and provide diversification. Diversification can also be found in individual companies that have revenues both in the developed world and emerging markets.
Chinese companies have relatively low PE ratios as investors are still not confident about the Chinese economy. Beware that we are not talking here about a recession, but only about growth worries related to China managing to continue growing at more than 6.7% a year.
Stay tuned to Investiv Daily for market updates and specific investment reports on emerging market stocks.