Emerging market positives

As anxiety over slowing gross domestic product (GDP) growth in China and possible interest rate hikes in the U.S. swept the globe, emerging-market (EM) equities – as measured by the MSCI emerging markets price index – plunged into bear market territory in late August. Prices fell by 21% from their April high. The mauling in U.S. dollar (US$) terms was worse, as plummeting EM currencies fuelled a 27% loss.

GDP growth rates in EMs have tumbled with the end of the China-led commodities boom. The International Monetary Fund (IMF) recently forecasted that EMs and developing economies will have a real GDP increase of 4% in 2015, the fifth year of waning growth.

Not surprising, many individual investors have fled from EM equities. Investors yanked US$6.1 billion from U.S.-traded EM equity exchange-traded funds in the quarter ended Sept. 30. Financial advisors with a long-term perspective, however, need to caution their clients to consider some critical facts.

First, EM stocks are much cheaper than those of their developed nation counterparts. As of Sept. 30, the MSCI EM price index had a price/earnings ratio of 11.6; a price/sales ratio of 0.9; a price/cash flow ratio of 7.4; and a price/book ratio of 1.3. The comparative valuation ratios for developed markets as measured by the MSCI world index are 36%-61% more expensive.

Second, even at a reduced pace, EM economies are expected to grow much faster than developed economies. The IMF’s baseline forecast is for EMs and developing economies to grow by 4.5% in 2016 and then by 5.3% annually from 2017 to 2020. These numbers far outpace the lacklustre 2.2% and 1.9% respective forecasts for advanced economies.

Cheaper stocks and faster growth suggest long-term returns may be higher in EM equities than for equities of the developed world. Newport Beach, Calif.-based Research Affiliates LLC recently updated its 10-year real-return forecasts for major asset classes. The forecast is that EM equities will deliver a 7.9% annual real return over the next decade. In contrast, the firm’s forecast for the much favoured and pricier U.S. stock market is a 1.1% annual real return.

Finally, there have been critical changes in the composition of EM equities. Materials and energy, which at one point comprised more than 25% of the MSCI EM price index, now comprise less than 15%. Financial services, technology and consumer goods constitute 26%, 20% and 17%, respectively, of the index.

Although the BRIC (Brazil, Russia, India and China) nations get all the headlines, roughly 58% of the capitalization of the MSCI EM price index is from other countries. Rapidly emerging second-tier countries such as Indonesia, the Philippines, Mexico and Colombia now comprise over 15% of the index.

Nonetheless, there clearly are risks to investing in EM equities right now. China may not be able to manage its transformation into a consumer-led economy without a major slowdown. Weaker commodities prices, particularly energy, could deepen the economic woes of Russia, Nigeria and Brazil. Thus, EM stock prices could drop even further. However, for the long-term investor, today’s valuations and return prospects are quite attractive.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.