Why Emerging Markets Are Looking Cheap (EEM)

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August 9, 2018 6:06am NYSE:EEM

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From BlackRock: As Russ Koesterich explains, dismal performance of emerging markets this year has make them look like a bargain again.

Following a stellar 2017, emerging market (EM) equities are once again on the back foot. The MSCI Emerging Market Index is trailing developed markets stocks by roughly 8% this year, despite rallying in recent weeks. Unlike the U.S., EM equities never enjoyed a real bounce since the late winter sell-off.

With the exception of a few outliers, notably Russia and Mexico, most of this year’s worst performing equity markets are EMs (see Chart 1). Developed market stocks, led by the United States, have recouped most of their winter swoon. In contrast, EM stocks are still down 14% from their January high in dollar terms.equities

The consequence of the selloff? EM stocks are once again looking like a bargain. Here’s why:

Valuations once again look cheap.

The MSCI Emerging Market Index is trading at 13.5 times trailing earnings and 11.3 times forward earnings. The former represents a 26% discount to developed markets.  Based on price-to-book (P/B) EM stocks look even cheaper, with a 30% discount to DMs the largest since the summer of 2016 and significantly below the post-crisis norm of around 17%.

Economic data is improving.

After a dismal spring, EM economic data is starting to improve, at least relative to expectations. This year’s underperformance coincided with a rapid deterioration in EM economic prospects. From late March through mid-June the Citi EM Index of Economic Surprises plunged from +40 to -25. In other words, economic data went from reliably beating expectations to chronically missing estimates. Since mid-June things have started to look better; economic data is strengthening relative to expectations.

The dollar rally has stalled.

The dollar remains a real threat to EM assets. That said, the Dollar Index (DXY) has been mostly contained the past two months. Unlike earlier this spring, European and Chinese growth prospects are stabilizing. At the same time, the dollar is no longer a crowded short, as it was earlier in the year. While a relatively strong U.S. economy still suggests an upward trajectory for the dollar, the ascent no longer looks so steep.

Risks remain.

A more constructive view on EM equities comes with three big caveats: financial conditions, trade and precision. As painfully demonstrated, despite secular improvements in current account positons and financial stability, EM assets are still vulnerable to tightening U.S. financial conditions. This is particularly true when Federal Reserve tightening is accompanied by a stronger dollar. With the U.S. economy experiencing good momentum, the Fed is likely to continue to tighten into 2019.

And while trade issues have faded in recent weeks, fundamental tensions with China have not been resolved. If trade concerns escalate, EM assets are vulnerable.

Finally, it is important to remember that EM equities are not a homogenous asset class. In reality EM is a heterogeneous collection of countries, with wildly varying fundamentals and valuations. Turkey is not Taiwan and Brazil is not Poland.

I see the best opportunities and value in EM Asia. While not without its risks, this segment of the world looks to once again offer some value.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

The iShares MSCI Emerging Markets Indx ETF (EEM) rose $0.05 (+0.11%) in premarket trading Thursday. Year-to-date, EEM has declined -6.07%, versus a 7.40% rise in the benchmark S&P 500 index during the same period.

EEM currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #10 of 88 ETFs in the Emerging Markets Equities ETFs category.

This article is brought to you courtesy of BlackRock.

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