I have had a number of discussions with clients recently regarding whether they should scale back their emerging market exposure. After all, emerging market stocks are up significantly since their lows of last autumn and have modestly outperformed more developed markets so far this year.
Despite recent strong performance, I believe there are two major reasons why investors should still have money allocated to emerging markets.
1. Cheap Valuations – First, and most importantly, emerging markets remain cheap compared both to their own historic valuations and to developed markets.
Currently, the MSCI Emerging Market Index is trading for around 12 times earnings. As the chart below indicates, this is significantly below the index’s long-term average multiple which is 16.
The current valuation of roughly 12x earnings is also a 22% discount to where the MSCI World Index is currently trading. Historically, when emerging market stocks have been at a 20% or more discount to developed market equities, they have significantly outperformed over the course of the next year.
2. Falling Inflation – A second factor which supports emerging market equities is that inflation continues to decline in most emerging markets (India is a noticeable exception).
For instance, over the past nine months, inflation in China has fallen from 6.5% to roughly half that level, while inflation in Brazil has dropped to around 5% from 7.5% prevously. These lower inflation levels should provide for earnings growth in emerging market stocks.
[CAVEAT - Emerging markets are not suitable for all investors. In addition, not all emerging markets look attractive so judicious allocation should be employed. If you have a financial adviser, I recommend that you consult with them. If you do not and would like to discuss whether you should be allocating to this sector, please contact me and I can arrange for a qualified financial adviser to get in touch with you.]