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Should Investors Underweight Emerging Markets Equities Today?

Stuart Brown

No. Emerging markets (EM) equities face a challenging macroeconomic environment, but many of the same issues are also plaguing their developed markets (DM) peers. We think EM allocations outside of China should be in line with policy, given that the risk of a widespread EM debt crisis is low, valuations relative to DM peers are undemanding, and certain regions stand to continue benefiting from high commodity prices. That said, we are more sanguine on Chinese equities and recommend that investors overweight them versus global stocks.

Aggressive monetary policy tightening by the Federal Reserve arguably warrants caution toward emerging markets, but the risk of a debt crisis is low relative to prior episodes. Today large emerging markets are less reliant on hard-currency financing and have increased their foreign exchange reserves over time. In fact, among the ten largest countries in the MSCI Emerging Markets Index, average external debt to GDP has fallen by roughly 10 percentage points since the late 1990s, whereas foreign exchange reserves to GDP have more than doubled. Spreads on USD–denominated EM debt have increased this year, but they remain below levels of concern. Economies with low foreign exchange reserves and wide current account deficits, such as Egypt and Turkey, look the most vulnerable, but they account for less than 0.5% of equity index market capitalization. The most acute risks lie in smaller frontier markets, where spreads on USD–denominated debt of certain fragile countries are higher than 1,000 basis points.

EM equity valuations today provide a buffer to more richly priced DM peers. Our normalized valuation metric for emerging markets ended May near median levels, while the same metric for developed markets was above the 90th percentile. On a relative basis, emerging markets has traded at a wider discount to developed markets only 11% of the time over the past 22 years. This has been driven, in part, by developed markets’ superior earnings growth and profitability. Looking ahead, we suspect that global earnings expectations are too high, and current above-trend earnings are concentrated in the DM bloc. EM earnings are roughly 14% below their longer-term trend, suggesting that any downward revisions to forward earnings expectations could have an outsized impact on developed markets.

Within emerging markets, Latin America (LatAm) and emerging Europe, the Middle East, & Africa (EMEA) may continue benefiting from elevated commodity prices. Their performance is the most sensitive to oil prices among major EM and DM regions. LatAm and EMEA (ex Russia) have returned 2.0% and -2.6% year-to-date in USD terms, respectively, outperforming both broader emerging markets and developed markets by double-digit margins. Analysts have also upgraded their forward earnings growth expectations for these regions. Highlighting the impact of these upward revisions, LatAm’s 12-month forward price-earnings ratio has actually fallen to near historical lows this year, despite its strong performance among global peers. Further, already weak currency values in these regions are likely to be supported, given that commodity exports make up a large share of GDP and central banks have tightened policy well ahead of DM peers.

But EM equities also face several challenges. First, the Fed is set to continue tightening monetary policy, which should support the US dollar as interest rates rise. Although risk of a debt crisis is limited, EM equity performance is negatively correlated with tightening US financial conditions. Second, there are signs that global trade growth is slowing, which would pressure earnings for the export-heavy Asia region. Finally, historical EM performance vis-à-vis DM has tended to be strongest during the early stage of the business cycle, which we are not in presently.

We think Chinese equities are the most attractive segment of emerging markets today, and we favor a risk-controlled overweight relative to global equities. The risks to Chinese stocks, including COVID-19 lockdowns, slowing growth, and regulatory concerns, appear to be priced in by markets. Chinese equities offer among the most compelling valuations across EM countries, and momentum relative to global stocks has started rebounding from oversold levels. In addition, Chinese policy is easing—in contrast to tightening in much of the rest of the world—which could allow for an economic rebound once COVID-19 concerns are alleviated.