Emerging markets took a drubbing earlier this year, but they've certainly swung back into favour with investors in quick fashion. The newfound popularity raises concerns that, like so many other assets in the world today, these stocks are approaching nosebleed territory. But they still have two things going for them: Cheap valuations and chronic underperformance over the longer term.
That might be hard to see if you focus on the near term. The iShares MSCI Emerging Markets exchange-traded fund, which tracks the indexes of developing economies such as China, India and Brazil, has rebounded about 17 per cent from its low in early February, after stocks had fallen over concerns about currency depreciation, high current-account deficits and tighter monetary policy.
Now, as Bloomberg News points out, Brazil's stock market is enjoying a bull market, defined as a gain of at least 20 per cent from its recent low. So is Turkey's stock market and, more remarkably, Russia's.
For the most part, the rallies fit into a broad trend: Investors have become far more comfortable betting that developing economies will successfully navigate the withdrawal of monetary policy stimulus from the U.S. Federal Reserve, without triggering a currency crisis or economic debacle.
The stock market gains have coincided with a substantial flow of money into emerging market funds. According to Bloomberg's numbers, a net $11-billion (U.S.) has moved into U.S.-listed exchange-traded funds in the second quarter, which is the most since 2012. What's more, many of these funds now trade at a premium to their underlying assets, creating the widest gap in two years. The inflows mark a substantial reversal from earlier in the year, when investors withdrew a net $31-billion in the first quarter.
But while it is easy to see that the best days of the rebound are over, there are at least two reasons why emerging markets remain a decent bet on an ongoing global economic recovery.
First, they're still relatively cheap, which provides some downside protection in the event of an economic setback and upside opportunity should these regions of the world continue to show economic growth that is considerably stronger than the developed world is capable of producing. According to Michael Hartnett, chief investment strategist at Bank of America, Russian stocks trade at less than 5-times estimated earnings, versus a price-to-earnings ratio of nearly 16 for U.S. stocks and more than 15 for Canadian stocks. Almost as good, Chinese stocks trade at less than 9-times estimated earnings and Brazilian stocks trade at about 10-times earnings.
Second, the rebound in emerging market stocks hasn't put them into record-high territory, suggesting more room for gains ahead. That's because they have underperformed most developed markets over the past several years: While the S&P 500 has risen about 85 per cent over the past four years, the iShares MSCI emerging markets ETF is unchanged.
Still need encouragement? GMO LLC, the global asset manager with $112-billion in client assets, believes that emerging market stocks offer the best potential for equity investors over the longer term. In their most recent forecast for seven-year returns, GMO estimated that emerging market stocks should gain 4.4 per cent a year, on average, after accounting for inflation. That's not great – but it's a lot better than their forecast of losses for U.S. stocks over this period and gains of less than 1 per cent for large international stocks.