Five Reasons Why It’s Not Too Late to Invest in Emerging Markets

So far in 2017, it’s been full speed ahead for emerging-markets equities, which have shown few signs of slowing down. The MSCI Emerging Markets Index has climbed almost 30% year to date,1 leaving some investors wondering whether it is now too late to gain exposure to this surging market segment.

In baseball terms, we believe the upward cycle of emerging markets (EM) is in roughly the third inning of a nine-inning game. In other words, we still see plenty of upside ahead and think it remains a good time to buy. Here are five reasons.

1. EM interest rates are still too high, especially compared to developed markets.

In the beginning of 2016, EM interest rates were very — and, more importantly, unnecessarily — high, even in the face of high inflation. The most extreme case was Brazil, where interest rates exceeded 14% when inflation was just 9%.2 A big reason for this was political noise, which has subsided somewhat as reforms have accelerated in many EM countries, such as India and Brazil.

However, as inflation remains benign, we still see significant room to lower rates across emerging markets, and this could spur higher equity returns.

2. The Chinese economy has stabilized.

So far, China’s economy has made a faster-than-expected shift from being manufacturing-based to more service-based. This is clearly a positive for China, which is a main driver of EM and global economic growth. Indeed, recent growth rates have been better than anticipated, supported by solid demand trends. China’s gross domestic product grew 6.9% in the first half, outpacing estimates.3

Furthermore, with the Chinese government aggressively shuttering excess capacity and deleveraging the country’s financial sector, the overall systemic risk has decreased significantly and should continue to fall in 2018. This has the effect of lowering the risk premium, which in turn elevates equity value for EM stocks.

3. Growth is rebounding more quickly in many emerging markets than in developed markets.

A very important reflection of that can be found in rising earnings expectations. We are seeing an increasing number of companies getting earnings upgrades — not only in Taiwan and South Korea (as has been typical) but in most parts of the world. This has been the second year of consistent earnings-per-share growth, and the last up-cycle lasted for five years, according to J.P. Morgan research.4

4. Valuations are compelling.

Overall, emerging-market equities have historically bottomed at 1.3 times price to book and peaked at 3 times price to book; they are now roughly at 1.7 times price to book.5 Based on this, we believe they still have room to run.

5. The U.S. dollar has been weakening.

This trend has provided the impetus for the past month’s momentum phase in the rally. Weakness in the dollar could continue if President Donald Trump fails to reach a pact with Congress on tax reform. If that happens, then we could witness more capital flowing into the EM asset class. Overall, EM currencies are undervalued against both the dollar as well as their historical norms.

Of course, there are risks to emerging-markets investing, including potentially greater volatility, currency fluctuations and political uncertainties. However, we believe an increasing long-term allocation to emerging markets is worth consideration, even though the rally is already under way. While we expect emerging markets to continue performing well, the easy money in this asset class has been made. As such, we anticipate that stock-picking ability will become even more critical, with a bias toward small- and mid-cap stocks from here on out.