Emerging markets have sold off sharply since May, as highlighted by the 22% drop in the iShares MSCI Emerging Markets Index exchange-traded fund. This tumble in a previously popular asset class is making valuations look tempting.
In a recent research report from J.P. Morgan Asset Management, George Iwanicki noted that the price-to-book ratio for emerging markets had fallen below 1.5. The ratio has previously been this low only six times during the past two decades; whenever that happens, stocks have rallied over the next year by more than 50%, on average.
Bank of America analysts have pointed out that global fund managers have their lowest equity exposure to emerging markets since November 2001. Such an underweight position in professional portfolios is often a bullish sign, from a contrarian perspective.
And emerging markets are trading at a cyclically adjusted price-earnings ratio (CAPER) near 13 when U.S. stocks are at 24. This is a dramatic reversal in relative valuation from 2007, when CAPER for emerging markets reached 37 compared to 27 for the U.S.
Yet, emerging markets still have great growth potential. The market value of stocks in the U.S. stands above 100% of gross domestic product, versus 40% for China, 45% for Indonesia, and 54% for India. “With rapidly growing populations, workforces, and rising productively, [emerging markets] have the ingredients to be the best stock markets,” writes Barton Biggs in his book, Wealth, War & Wisdom.
Why has the sell-off occurred? In 2012 and early 2013, economic slowdowns in China, Japan, Europe, and the U.S. reduced demand for the commodity exports of emerging countries. Trade balances worsened and put downward pressures on currencies. Then “tapering” talk by the Federal Reserve caused U.S. bond yields to shoot up and draw back the capital that had earlier flowed into the emerging markets, putting more downward pressure on financial markets and currencies.
But a serious meltdown like the one seen in the late 1990s is unlikely, says The Economist. Back then, emerging markets had fixed-exchange rates and large debts denominated in foreign currency. Within this framework, capital can stampede for the exits at the slightest hint of a currency devaluation that makes the cost of paying foreign loans prohibitive. Now, emerging markets have flexible-exchange rates, much less foreign debt, and substantially larger reserves of foreign currency.
Moreover, we are still in the stimulative phase of monetary policies. The recent sell-off could just be the typical overreaction seen when the first cloud casts its shadow on the economic landscape after a long streak of sunny days. As a recent Interim Economic Assessment released by the OECD notes: “Unemployment is high and underlying inflationary pressures are weak. Core inflation is generally running below official medium-term inflation objectives. Hence, considerable monetary policy support should remain in place.”
As for the global economic slowdown, the big economies are now finally gaining steam (thanks to the hugely stimulative policies of previous years). A key leading economic indicator, the purchasing managers index (PMI) for manufacturing, climbed above 50 in Europe and Japan a few months ago, while the PMIs for China and U.S. ticked up even higher above the 50 level (a reading above 50 indicates an expanding economy).
The pick-up in global growth bodes well (after the customary lags) for a revival in the exports of emerging countries. In addition, the substantial currency depreciations experienced by emerging countries since May make their exports even cheaper to buy. With the setback likely being short-term in nature, valuations look tempting.
Larry MacDonald is a former economist who manages his own portfolio and writes on investment topics. He is the author of several business books and tweets at @Larry_MacDonald.