Michael Santoli

Buy the (next) dip in emerging-markets stocks

Big taper losers – and winners – in emerging markets
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Brazil, Indonesia, Turkey, India, and South Africa were all hurt when taper talk started in May. Which ones will continue getting hurt and which ones will rebound? Two strategists give their take.

Shovel ready?

Investors should prepare to scoop up some emerging-markets stocks for cheap, long-term exposure to world growth, especially in the event of one more big dump in the sector.

Faith in the developing-world growth leadership story has already flagged badly. The iShares MSCI Emerging Markets exchange-traded fund (EEM) is down 5% over the past three months and has been thumped by the Standard & Poor’s 500 index by more than 35 percentage points over the past year. On Thursday the index was at its lowest level in almost two weeks amid a broad market selloff following a surprise decline in China manufacturing, with emerging currencies also sinking.

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If EM underperformance is destined to climax in raw panic and indiscriminate selling, rather than building malaise, we’re not there yet. The charts of most of these markets look undeniably weak from a technical perspective, showing daunting selling pressure at work. Still, EM is becoming too cheap for investors to continue ignoring as they array their long-term bets.

Emerging markets cast aside

The sturdier expansion and heady equity gains in the U.S., signs of revival in Europe and the stimulus-shock surge in Japan are now captivating global investors. In contrast, emerging equities are being cast aside amid slowing industrial activity, the commodity-price downturn and fears of currency meltdown as the Federal Reserve dials down its money creation.

Whether Wednesday night’s disappointing Chinese manufacturing data, the struggles of Brazil and Turkey to defend their currencies or Indonesia’s new curbs on iron-ore exports, reasons abound for investors to permit themselves to avoid these struggling economies that feature seemingly spring-loaded risks of capital flight.

As a result, says Bank of America Merrill Lynch chief investment strategist Michael Hartnett, among investors, “emerging markets are about as popular as Dennis Rodman at a UN Security Council meeting.”

Sizing up specific country markets against individual mega-cap U.S. stocks, Hartnett notes the relative enthusiasm for each market segment is stark: Google Inc. (GOOG) alone has a higher market value than the entire MSCI Brazil index, Wells Fargo Co. (WFC) is now “bigger” than India and Starbucks Corp. (SBUX) is “worth more than Turkey, which for eons has been synonymous with strong coffee in convivial settings."

Hartnett notes that rarely have investors had such optimistic views of global growth prospects while so severely underweighting investments in emerging markets. While he believes some combination of a Brazil debt downgrade, Chinese financial-system rupture and currency fallout raises the chance of some kind of “EM crash,” he also suggests these risks are substantially appreciated and so investor “EM capitulation [is] close.” 

Michael Darda, chief economist and strategist at brokerage MKM Partners, offers that “It is precisely when the news is bad and the outlook uncertain that valuations will be stretched to the downside, as they are now.”

Darda continues: “Relative to developed markets, EM equity valuations are now below their low point in the fall of 2008. Although valuations could always go lower in the near term, we are rapidly approaching levels on relative valuations that historically have been a setup for outperformance in the not-too-distant future.”

There is plenty of talk these days that the old conception of the emerging markets as a single investment bloc might not be very useful. It's no doubt true that South Korea and Mexico, for instance, are driven by far different fundamental forces than South Africa and Indonesia are. Each major country has its own exchange-traded fund for those willing to drill down and make narrower bets.

Cheap enough

Yet it’s getting to the point where emerging markets as a whole has become cheap enough that they should promise some of the better multi-year forward returns available in today’s otherwise buoyant world market.

Institutional asset manager GMO follows a disciplined quantitative value-investing strategy and has a fine track record in forecasting asset-class prospective returns over the longer term. Its latest forecast is for generally subpar inflation-adjusted performance for most investment categories over the next seven years. For large U.S. stocks, as an example, GMO sees small annualized real losses of 1.7%.

The most attractive in its framework is, no surprise, the most hated: Emerging-market equities are projected to deliver 3.5% annualized after inflation over the next seven years (and EM debt next best at 2.9% a year).

That may not sound like much given the worrying headlines and potential near-term panic-trade risk. And these markets might have to be harshly tested by the ongoing Fed “tapering” process of reduced asset buying as the year unfolds. But it’s a pretty good gauge of relative value in a broadly expensive global market, and buying cheap is always a pretty good way to tilt the odds in one's favor.

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