Emerging Markets: Four Reasons for Caution, Not Abstinence

In the space of three years, emerging markets have gone from a key strategic asset class, one favored by many investors, to persona non grata.

More than $10 billion flowed out of emerging market (EM) exchange traded funds (ETFs) in 2013, and since the start of the year, the outflow has only gotten worse. Political turmoil in Turkey and Ukraine, coupled with devaluation by Argentina, has served to add to investor angst.

But while I share investors’ concerns on the near - term outlook for EM assets, I don’t agree with the notion that EM equities have gone from a strategic asset class to one that should be completely shunned. As I write in my new Market Perspectives paper, Emerging Markets: Caution, Not Abstinence, there are four key reasons why EM assets still deserve a place – or at least a diminished place – in most portfolios.

1. Recent EM volatility is not abnormal. Many investors are being scared off by EM volatility, but it’s important to note that recent volatility is not abnormal. The recent past is actually more representative of EM investing than the unusually placid period of the past several years, a period in which markets were unusually quiet due to unconventional monetary policy by the major central banks.

According to World Bank estimates, massive asset purchase programs from large, developed country central banks were responsible for 60% of the capital flows into EM assets between 2009 and 2013. With that much money flowing into EM assets, it should come as no surprise that volatility was temporarily low. But now, as quantitative easing (QE) is coming to an end, at least in the United States, we are returning to a more normal EM volatility environment.

2. Over long periods of time, EM assets have benefited most portfolios. This is the reason that investors have historically put up with EM’s higher volatility. However, many investors today seem to have forgotten that while EM assets have tended to go through dramatic and often prolonged busts, they have also outperformed developed markets over the long term. In fact, EM equities have outperformed their developed market counterparts by about 1.5% annually since 1950 on average. At least historically, EM assets have produced returns high enough to compensate for their additional volatility.

3. EM assets help diversify portfolios. While it’s true that EM stocks and bonds have become increasingly correlated with developed market securities, the correlations are still lower, suggesting some lingering diversification benefit.

4. EM stocks look inexpensive, at least compared to developed markets. EM equities look cheap, less in an absolute sense, but in a relative sense. As much of last year’s rally—particularly in the United States—was driven by multiple expansion, EM stocks look much more reasonable when compared to those in developed markets. Based on a trailing price - to - earnings ratio, EM stocks are trading at roughly a 40% discount to developed markets. It’s on this metric, relative valuation, that the value case for EM looks most compelling.

To be sure, a strong dollar has rarely been a friend to EM stocks. In addition, while EM valuations are lower, so too are the markets’ growth rates. Perhaps even more importantly, divergences between EM countries and sectors are likely to widen, and there are still a few “problem children” EMs that are likely to suffer additional volatility and more downside going forward.

In addition, for those countries with large current account deficits, further currency depreciation may be required to address their imbalances (As a side note, you can read more about how the various EMs stack up¸ as well as the tactical arguments for and against increasing EM exposure, in the new BlackRock Investment Institute Paper “Emerging Markets on Trial,” and compare different EMs’ fundamentals with the Institute’s Emerging Market Tracker tool.)

This all begs the question: how much should today’s EM allocation deviate from a long - term benchmark? The answer is largely dependent on an investor’s current positioning. Particularly when it comes to a volatile asset class like EMs, investors need to consider how much risk they want to take on before they arrive at any asset allocation.

But for a theoretical investor who is willing to take on at least moderate risk and who is already at or near his or her benchmark EM allocation, I see significant opportunities to differentiate among EM countries, sectors and stocks, especially given EMs’ diverging currency outlooks, political calendars and current accounts. You can read more about which EMs I like in my new Investment Directions outlook.

Source: BlackRock research

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets.

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