Russ discusses why the case for emerging market stocks right now simply rests on concept of solid global growth.
The mood in Davos was buoyant and the IMF just upgraded estimates for global growth. Cynical investors could be forgiven for viewing both of these developments as contrary indicators. Nonetheless, growth does appear solid, with most real-time and leading indicators suggesting some acceleration.
Given the run-up in economically sensitive assets, many investors appear to be buying into this thesis; witness the surge in industrial metal prices (see the chart below). For investors looking for an equity play on global growth, consider a higher allocation to emerging market (EM) equities.
It’s not just about the dollar
Before focusing on the case for emerging markets, it is worth disposing of two myths: EM stocks are cheap and they are a play on a weak U.S. dollar. While both have some validity, they oversimplify the case.
Today, like most asset classes, EM stocks cannot really be described as cheap. They are trading close to their historical norm, both on an absolute basis and relative to developed markets; the MSCI Emerging Market Index is currently trading at about a 25% discount to developed markets, in line with the long-term and post-crisis average.
Many investors would also point to a weak dollar as a catalyst for EM stocks. The truth is more nuanced. Historically, there has been a negative relationship between EM stocks and the direction of the dollar. That said, the relationship is modest, explaining less than 2% of the variation in monthly relative returns. And even that may not be the case going forward. To the extent EM countries have become less dependent on dollar funding and have improved their current account balances, they are less vulnerable to changes in the dollar.