Do emerging markets offer better value than the US, UK and Europe?

At first sight, there are reasons to feel anxious, but David Prosser explains why now could be a good entry point to invest in fast-growing economies. 

Market turmoil is supposed to be bad news for investors in emerging countries. At times of stress, investors naturally gravitate towards markets they perceive as safer and more stable – the developed economises of the world. It might surprise you to learn, then, that in a miserable first half of the year for global equities, emerging markets outperformed their developed counterparts.

Moreover, the gap was significant. By the end of June, the MSCI World Index was down 16.6% compared to the beginning of 2022. MSCI’s Emerging Markets Index, by contrast, registered a fall of 12.3% over the same period – and China, the biggest emerging market of them all, actually delivered positive returns in the second quarter of the year, something no other major market could manage.

Part of the explanation lies in where markets started 2022. “Developed markets have ridden high for a decade on cheap money and negative real interest rates, with valuations reaching extreme levels, while the MSCI Emerging Markets Index sits at similar levels to where it was in 2007,” points out Ewan Thompson, a fund manager at Liontrust.

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Thompson adds: “Quantitative easing has famously been hard on emerging markets, with their equity markets largely having been bypassed by the bull market experienced in the developed world.

“But emerging markets have generally used this time productively, executing prudent policies and repairing their economies.”

That begs an obvious question. Are emerging markets now a better bet than those in the developed world for the rest of 2022 and beyond?

Reasons to be bearish on emerging markets

At first sight, there are several reasons to feel anxious. While Western governments are increasingly unnerved by rapidly accelerating inflation, the problem is even more acute in many emerging markets. Rising food and energy prices, where global inflation is concentrated, hit many emerging markets hard, because people in these countries tend to spend more of their disposable income on such necessities.

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Another concern is the recent strength of the US dollar, boosted by its status as a safe-haven currency in troubled times. A stronger US currency spells bad news for emerging markets with significant amounts of dollar-denominated debt – the likes of India, Brazil, Mexico and Indonesia, for example. In nations with structural economic problems, such as Turkey and Argentina, this is a particularly pressing issue.

China also represents a potential headache, despite those second-quarter gains. Investors continue to worry about the Chinese government’s apparent determination to regulate the country’s powerhouse technology companies more aggressively, about politicians’ insistence on a zero-tolerance policy towards Covid-19, which means frequent lockdowns, and about the deep-seated problems in its debt-ridden property market. If China can’t overcome these difficulties, the prospects for emerging markets as a whole are grim.

Bull points

For many analysts, however, the positive case for emerging markets outweighs these downside risks.

“The prospects for emerging market investors should be stronger as we go through the second half of the year and move into 2023,” argues Paras Anand, chief investment officer at Artemis Investment Management.

He adds: “This view is based on three primary considerations – a better outlook both for the economy and corporate earnings in China, the lower sensitivity of Asia more broadly to higher input prices and the potential for higher fiscal spending in the US to benefit Latin American economies.”

Nick Price, portfolio manager at Fidelity Emerging Markets (LSE:FEML), is also upbeat. “We believe that fundamentals will return to the fore as the unprecedented fiscal and monetary policy support begins to fade. Certainly, meaningful value has emerged as stocks have derated significantly and the overall discount to developed markets is wide.”

Dzmitry Lipski, interactive investor’s head of funds research, shares that cautious sense of optimism. He says: “Valuations do look attractive given emerging markets are trading at a discount to developed market equities. While recent heightened market volatility shows that emerging markets could pose significant risks, they do still present attractive opportunities for long-term investors.”

A counter argument to the doom and gloom

As for the threats to emerging markets, it is possible in many cases to make a counter argument.

On inflation, in particular, many central banks in emerging markets have been far quicker to act on rising prices. Brazil raised interest rates 11 times over the year to June, for example, while countries such as Mexico moved well ahead of the US Federal Reserve to tighten monetary policy. The result is that inflation has not spiralled out of control in most emerging markets in the manner we have seen in the past – and these countries now have more room to ease policy in response to a global economic slowdown.

In any case, while the concern about higher food and energy prices hitting emerging markets harder holds true, it is worth pointing out that some countries are benefitting from the latter. Commodity-rich nations in Latin America and the Middle East are obvious examples. Demand for their exports should also help protect their currencies from the strength of the dollar.

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Hopes for a recovery for China shares

As for China, the more bullish case for its economy and stock market rests on expectations that officials will take a pragmatic view. “We are starting to see the first signs of easing from the People’s Bank of China,” says Artemis’s Paras Anand. “It suggests the recent aggressive measures to redirect the economy towards a sustainable growth model may have run their course for the near term.”

Indeed, points out a briefing just published by Lazard Asset Management, Chinese officials have publicly stated their support for the country’s technology companies in recent months, Covid-19 lockdowns have become less frequent, and the property market has shown signs of greater resilience. “While global expectations and sentiment have been muted for China, a market that has struggled over the past 15 months, often this type of environment marks a good time for investors to uncover new opportunities – and companies that are attractively valued,” Lazard argues.

There are no guarantees. In the end, emerging markets are facing the same dilemmas as their developed counterparts. Policymakers in every country are engaged in a difficult balancing act, trying to keep economies growing while dealing with the scourge of higher inflation.

Arguably, however, emerging markets are in a better position to walk this tightrope, because many of them are already at a later stage in the monetary policy tightening cycle. And there can be no over-estimating the importance of the leading nations. Thompson adds: “A stabilising China is an extremely powerful positive force. And we should not forget about the ongoing robust performance of India, which has consistently outperformed both developed and emerging markets since April 2020.”

Cheap as chips

Then there’s the valuation point, made by so many managers and analysts. Why wouldn’t you take a closer look at emerging market equities when their average price to earnings ratio suggests they trade at a 30% discount to developed markets?

Ultimately, says Scott Gallacher, a chartered financial planner at independent financial adviser Rowley Turton, many investors will want to have some emerging markets holdings in their portfolios, given the prospects of long-term outperformance, even if volatility is higher in the short term. “There may be many stock-specific examples of well-established emerging market companies that offer excellent value,” he adds. “And, if emerging markets follow the current worldwide investment trend of investors reverting to looking for value as opposed to growth, these companies may do very well.”

Emerging markets funds to consider

Caution and selectivity are vital in emerging markets investment given the huge diversity of countries and economies available, warns Lipski. He picks out three funds to consider for emerging markets exposure in the current environment: “Stewart Investors Global Emerging Markets Sustainability fund invests in high-quality mid-to-large-cap companies that are considered to be well positioned to contribute to and benefit from sustainable development, with a focus on delivering long-term capital growth over market cycles. Half the portfolio is invested in technology and consumer staples sectors, with almost 70% allocated to the emerging Asia region.

“Mobius Investment Trust (LSE:MMIT) provides actively managed exposure to the emerging and frontier markets investment theme, while also focusing on environmental, social and governance (ESG) issues. The strategy was launched in 2018 and invests in a highly concentrated portfolio of around 25 to 30 high-quality stocks for the long term.

“Fidelity China Special Situations (LSE:FCSS) trust provides broad, diversified exposure to Chinese equities. Due to the trust's single country exposure, its bias to small and mid-sized companies and its ability to use gearing, its return profile is likely to be more volatile, making it higher risk and an adventurous holding in a well-diversified portfolio.”