Three Reasons to Consider EM Asia

While the economic and monetary environment remains supportive of equity markets, not all stocks have been benefiting lately.

Emerging markets (EMs) witnessed $1.4 billion of Exchange Traded Product (ETP) outflows last week. In a reversal from EM stocks’ summer rally, the asset class has been struggling of late on concerns over increasingly erratic Russian policy, slower Chinese growth and higher U.S. rates.

But despite EMs’ recent performance, I still believe that EM stocks represent a long-term opportunity and that investors underweight the asset class should consider bringing their exposure back up to at least a market weight. EM equities appear reasonably priced in a world with few bargains, especially given recent positive election outcomes, signs of structural reforms and the reality that China is still growing at a decent pace.

That said, not all emerging markets are equal, and I continue to advocate that diverging EM valuations, fundamentals and policy outlooks warrant a selective approach.

This begs the question: Where in the EM world do I see opportunities? As I write in my new Market Perspectives paper, Emerging Markets: A Closer Look, on a relative basis, EMs in Asia, including China, appear particularly attractive. Here are three reasons why.

Relative valuations. Within the emerging world, Latin America is the only region that is trading at a premium to its historical average, thanks to a sharp climb in Brazilian equities without a corresponding increase in earnings. Meanwhile, EMEA is trading at a significant discount compared to its history, thanks to the persistent and understandable discount on Russian equities.

In contrast, EM Asia valuations are currently largely in line with their historical average, providing some room for future multiple expansion should EM fundamentals continue to improve. This is especially true considering that much of EM Asia’s current valuations can be attributed to relatively cheap Chinese valuations that appear to be discounting an even greater economic slowdown in China than what has been witnessed to date.

Relatively strong economic growth. Despite some signs that Chinese growth momentum is reversing from previous highs, the Chinese economy is still growing at a decent pace and government officials seem committed to growth of around 7%. In addition, local governments have implemented efforts to stabilize growth and support local property markets.

Elsewhere in Asia, fundamentals are not only stabilizing but in a few noticeable instances improving. Compared to other regions, emerging market countries in Asia appear to be experiencing a more pronounced cyclical upswing. For example, while India’s growth rate remains well below the 10% it briefly hit several years ago, it has recovered from its recent slowdown.

Improving growth is also evident in the recent improvement in manufacturing surveys, which have turned higher in contrast to those in Latin America and Eastern Europe. In addition, given Asia’s large trade sector, the region is likely to be the biggest beneficiary of the recent upturn in U.S. growth.

Less exposure to reversals in capital flows. With the exception of Indonesia and India, the major countries in Asia have generally sizeable current account surpluses. And even in the case of India and Indonesia, both countries have posted significant improvements in their current accounts.

As a result, the region has been, and is likely to continue to be, more resilient to higher U.S. yields—should they ever actually rise—and any potential interruption of capital inflows. In comparison, despite moderate current account adjustments, Latin America and EMEA are still running large deficits, and remain vulnerable to flight-of-capital if the Federal Reserve (Fed) raises rates sooner or more aggressively than expected,

To be sure, risks remain, most notably the extent and depth of China’s debt and real estate problem. While I believe the fear of a property slump in overdone, investors should pay careful attention to both Chinese property prices and loan growth.

That said, for now, I believe the risks are contained. The bottom line: While EM Asia is not without its risks or downsides, it offers something exceptionally rare in today’s market: the potential for an undervalued asset class.

Sources: BlackRock, Bloomberg     

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist.

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