Emerging markets (EM), one of the most unloved asset classes of the past few years, have recently proven to be a bright star in the market. As global equities posted another strong week (hitting fresh year-to-date highs across a number of markets), EM continued to strengthen. Its success thus far in 2016 raises a question on an asset class that has struggled for most of the past five years: Is EM finally back?
The EM asset class posted a great first quarter, gaining 5.7%, as measured by the MSCI Emerging Markets Index. Several EM markets did exceptionally well, with the MSCI Latin America and MSCI EM Eastern Europe indices posting advances of +19.1% and +15.0%, respectively. Higher commodity prices, combined with an improving investor risk appetite and dovish global central banks, as well as a weakening dollar, helped to fuel much of the rally. EM’s success this year has been a great trend reversal of losses in the past three calendar years, including a -14.9% decline in 2015.
Its struggles have also negatively affected well-diversified portfolios, which have experienced a rally driven predominantly by US large cap over the past three years. Although we have definitely seen weak years recently for EM, it is important to remember that it can often lead by very wide margins. Over the 10-year decade from 2000-2009, in which the S&P 500 posted a loss of 9.1%, the MSCI Emerging Markets Index gained 154%, easily outpacing most major asset classes.
Despite its struggles of the past few years, strong reasons support owning EM, many of which investors have ignored. From a valuation perspective, MSCI Emerging Markets are trading at a forward P/E of 11.9, compared with 15.6 for the MSCI ACWI Index, and 17 for the S&P 500 Index, and also at a lower relative value from historical levels. From a diversification standpoint, owning EM helps portfolios gain access to countries that are experiencing growth at different times in their economic cycles, and often at higher rates, than the U.S.
Much of the negativity surrounding EM in 2015 was the Federal Reserve’s (Fed) looming rate hikes and the potential negative impact they would have on developing countries. Heading into 2016, the Fed was expected to raise rates four times this year. However, weaker-than-expected global economic data and indications from the Federal Open Market Committee (FOMC) suggest that we are still a ways off from the Fed’s moving aggressively to raise rates.
For the time being, EWM believes EM is definitely back. Whether the trend continues for investors buying into the story of a recently unloved asset class, or we see another reversal out of EM, only time will tell. One thing is certain: EM has posted outstanding gains in the past, often when other asset classes are struggling, and its success may mark the return of diversification.
