“Valuations are low now,” says Jun Zhu, a senior analyst with the Leuthold Group, an institutional research firm in Minneapolis, “and there are signs that emerging markets could outperform U.S. stocks going forward.”
The lackluster performance has been a recent phenomenon. Generally, emerging markets stocks have been stellar since 2000. Morningstar’s diversified emerging markets stock fund category had 10-year annualized returns of nearly 9% through the first quarter of 2014, while the five-year average return topped 14%.
But those same funds have had negative returns of 2% per year since 2011; some regional categories have fallen more sharply, with Latin American stock funds down 9% per year.
Part of the recent weakness was due to rebalancing, Zhu says. From early 2009, when markets were reeling from the financial crisis, through 2012, the MSCI emerging markets index more than doubled, outpacing the S&P 500.
Last year, however, investors took profits to reset their asset allocations, and the selling lowered stock prices in the emerging markets.
A trigger of the 2013 selloff was Fed Chairman Ben Bernanke’s announcement of a “tapering” policy—slowing down the monetary stimulus.
As PricewaterhouseCoopers stated then, “The deployment of unconventional monetary policy instruments since 2009 has disproportionately benefited emerging markets.” Essentially, money flowed from developed to emerging markets in search of higher yields and plumper profits.
In 2013, the prospect of tighter money in the U.S. and other major economies reversed this capital stream, depressing currency values as well as stock market prospects in the emerging markets.
Why could there be a re-reversal now, buoying emerging-market equities? Valuations are relatively low now, Zhu says, especially in European countries, including Russia. “Currencies have stabilized,” she adds, “now that the ‘hot money’ has left these countries and there’s less speculation. Fund flows look better, too: there were huge outflows in 2013 and early 2014 but while it’s still too early to say for sure, the inflows of the last few weeks are encouraging.”
Investor sentiment may also be sending a positive signal. Referring to the widely held iShares MSCI Emerging Markets Index ETF, Zhu says: “Short interest in EEM was higher in 2013 than it was in the 2008 financial crisis. That was an amazing level. Now, short interest in EEM is down from the peak.” Zhu believes that emerging markets stocks were oversold last year because of excess pessimism, so it may be time to increase allocations.
Zhu is especially upbeat on the prospects for small-cap stocks in the emerging markets, as those companies tend be geared toward domestic economies, where relatively rapid growth is expected. Some ETFs track indexes of small-company emerging markets stocks.
Moreover, as Zhu points out, “some actively managed funds have had success investing in emerging markets,” so financial planners have multiple ways to mull expanding exposure within this asset class.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.
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