Russ Koesterich: In recent months, as the United States, Europe and Japan have continued to wrestle with their various fiscal problems, emerging market economies have shown signs of improvement. It’s no wonder, then, that investors have flocked to emerging markets. After weak performance through much of 2012, emerging markets gained roughly 1% in November and nearly 5% in December.
But now many market watchers are wondering whether the emerging market trade is still a smart one.
In my opinion, the answer is a resounding yes. Here are two reasons why I think there’s room for further emerging market gains in 2013.
Mounting evidence of faster growth: The growth outlook for emerging markets has improved in recent months. While China and other large emerging market countries are highly unlikely to achieve double-digit growth anytime soon, or ever, their growth should be higher in 2013.
Take China. The country’s economic outlook has improved significantly over the last few months. As recently as July, China’s exports were growing at a paltry 1% year over year. As of December, exports were growing 14% from a year earlier. Similarly, Chinese manufacturing gauges have picked up recently and Chinese commodity imports (an important sanity check in a country in which official data is often questioned) have sharply accelerated.
The recent improvement in China’s economic outlook is likely to benefit China’s stock market as well as the emerging markets in China’s orbit such as Brazil (China is critical to Brazil’s commodity sector).
The markets are still cheap: Even after the recent rally, emerging market stocks look particularly inexpensive compared to their developed market counterparts, especially considering emerging markets’ improved growth outlook. Based on price-to-earnings ratios, developed markets are trading at a 50% premium to emerging markets, the largest such premium since late 2009. And historically, premiums this large have generally been associated with emerging market outperformance over the next twelve months.
Brazil is just one example of such cheap valuations. Of all the large emerging markets Brazil is one of the cheapest, with the market trading at less than 10x forward earnings and barely 1x book value. Valuations at this level look particularly attractive given the country’s current inflation rate of 5.5%, a moderate rate for Brazil. Assuming Brazil’s inflation remains at current levels and the country’s growth picks up this year as I expect, valuations have significant room to expand. I also believe that Brazilian equities’ recent sluggishness is a sign that investors haven’t given the market proper credit for recent structural reforms.
In short, with their faster growth and still cheap valuations, I believe emerging markets are poised for more appreciation in 2013 and I’d advocate sticking with the emerging market theme. In particular, I continue to like China, Brazil and Russia and for investors seeking a less volatile strategy, I like the iShares MSCI Emerging Markets Minimum Volatility Index Fund (NYSEARCA:EEMV).