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Cheap emerging markets

Emerging market investors are nursing some big losses, but there is hope for them, because markets might now be pricing in a lot of bad news.

It’s easy to see why emerging market equities should be suffering. The Fed will continue to raise interest rates this year, and anyone with memories of 1994 knows that even anticipated rises in rates can be bad for the sector. The stronger US dollar is also a problem, as it raises the costs in local currency not only of importing raw materials but also of servicing dollar-denominated debt. High oil prices are yet another danger. Ordinarily, these aren’t bad for emerging markets because they are a sign of a strong world economy, a circumstance in which emerging markets often do well. Today, though, they are a sign of restricted supply as a result of the Russia-Ukraine war, so equities are getting pain without gain. And on top of all this, momentum is against them. MSCI’s emerging markets index is below its 10-month average – a fact that has sometimes led to huge falls.

The case against emerging markets is therefore strong.

But not overwhelmingly so. The ratio of MSCI’s emerging markets index to its developed world index is now one-third below its post-1990 average. Which is encouraging because there has been a tendency for emerging markets to do well after this ratio has been low. On the last occasion when the ratio was as low as it is now (in October 2002) they rose by 44 per cent in the following 12 months.

There’s a reason why emerging markets are so cheap. It’s that investors have wised up and are now pricing in more bad news than they usually do.

For years, variations in annual returns on emerging markets have been largely due to just a handful of factors: returns in developed markets; valuations; and the level and change in the US dollar and interest rates. These alone have explained three-quarters of the variation in annual returns on emerging markets since 1992.

In recent months, however, the sector has done worse than these factors predicted. Ordinarily, a low fed funds rate, rising US equities (the S&P 500 is 12.7 per cent up in the last 12 months) and rising bond yields are circumstances in which emerging markets do well. But in fact they have fallen 13 per cent in US dollar terms in the past 12 months.

One reason for this is that the rise in developed world equities has not been broad based but has in fact been unusually concentrated in big tech and the oil majors. We wouldn’t expect many emerging market equities to benefit from that.

Also, the traditional relationship between US bond yields and emerging markets has broken down. Often, emerging markets have done well when bond yields have risen, because rising yields are a sign that investors’ appetite for risk is increasing – and when it does, emerging markets do well.

Recently, though, emerging markets have fallen while bond yields have risen. There’s a simple reason for this. Investors expect US interest rates to rise and knowing that higher short rates are bad for emerging markets, they have sold them in advance of the rises.

Which is now good news for investors. It suggests that one big danger for emerging markets is now in the price. A repeat of 1994 is thus not likely.

Of course, whether this leads to emerging markets rising depends a lot upon Vladimir Putin. An end to the war would benefit emerging markets in three ways. In decreasing uncertainty it would increase investors’ appetite for risk. It would weaken the dollar as investors no longer feel the need to cleave so much to familiar assets. That would cut the costs of raw materials and debt servicing. And in reducing the threat of supply restrictions it could cut the oil price.

By the same token, though, a continuation of the war would hurt emerging markets more than most.

Which is of course just another way of stating the obvious – that emerging markets are risky.

What’s not so obvious, though, is that emerging markets are now so cheap, and have so much underperformed the usual predictors of their returns, that they are discounting lots of bad news. And, remember, investors in emerging markets are sometimes very well rewarded for taking on risk: we saw annual returns of over 50 per cent in 1991, 1993, 1999, 2003-04, 2009 and 2020-21, for example. Sometimes, fortune does favour the brave.