If you’ve been holding off on buying U.S. stocks because you’re wary about an upcoming correction, it’s time to check out emerging markets (EM).
Their correction has already happened. So they now look cheap. And near-term catalysts lie ahead, chiefly in the form of a decline in fears about a trade war, which will chip away at the dollar and drive EM shares higher.
The correction: As of last week, the MSCI Emerging Markets Index was down almost 20% from its late-January highs, compared with about a 1% decline in the S&P 500 Index SPX, -0.04% That’s reduced emerging market stocks to their 10-year average valuation, a nice discount to where they were in January when the dumb-money crowd was piling in.
Now everyone hates EM again, so it is time to buy. Here’s what could send EM stocks higher, and seven ways to get exposure.
1. The dollar will weakenWhile problems in Turkey recently put developing-country risk in the headlines, most of the EM stock market decline has actually happened since the dollar started rising from its bottom in April.
This makes sense because a strong dollar hurts emerging markets in two ways.
• A lot of emerging market companies sell commodities, and a strong dollar hurts commodity prices.
• Many EM governments and private companies have lots of debt denominated in dollars. So weakening EM currencies (i.e. a strong dollar) raise fears that they will have trouble paying back the debt.
Now the dollar is poised to fall, which will have the reverse effect. This will push EM stocks back up.
Why is the dollar about to fall? It went up on fears about trade wars. Now, trade-war fears will ease because President Donald Trump is smart enough to know he doesn’t really want one.
Sure, there’s still a lot of bluster from the White House about tariffs. But this is just a bargaining tactic to get foreign governments to soften up. And it seems to be working. China recently showed signs of folding on the trade-war issue, and bilateral talks on trade resumed.
In the background, the U.S. economy will slow after a robust second quarter. Heading into mid-term elections, Trump doesn’t want trade-war rhetoric to hurt the economy even more than it already has. So he’s ready to bargain, too.
“If the U.S. economy slows now, everyone is going to point to trade wars as the culprit. There will be pressure on Trump to get a resolution,” says James Paulsen, chief investment strategist at The Leuthold Group. A lot of that pressure will come from within his own party, says Paulsen.
“I am optimistic that trade will get worked out,” agrees Charlie Wilson, co-portfolio manager at the Thornburg Developing World Fund.
2. The global economy will be fineMany investors are fleeing emerging market economies for the U.S. “safe haven” because of fears about a slowdown in global growth. But this is mistaken. “Global growth is weak relative to last decade, but it is still chugging along,” says Wilson.
That will continue. Many central banks around the world are still easing, rather than tightening like the Fed, he notes. China has been lowering interbank lending rates and boosting infrastructure spending. Yields on 10-year bonds there have been falling, which encourages borrowing.
Next, emerging market economies are still in the early phases of their recoveries. Banks are looking healthier in Indonesia. The consumer is strong in India, where companies are posting better results as well, says Wilson. Most emerging market economies have younger populations than developed economies, which is good for growth.
“If the dollar comes off and the global economy stays in place, then I think you get a pretty healthy bounce in emerging markets,” says Paulsen.
3. Emerging markets are cheapThe MSCI Emerging Markets Index trades at 11 times forward earnings, which is on par with its 10-year average, points out Wilson. That may sound ho-hum as a valuation. But you have to keep in mind that the composition of this index has changed in a way that means it should have a higher valuation than in the past, says Wilson.
It now has a lot more tech companies like Alibaba BABA, -0.04% Tencent TCEHY, +2.04% and Samsung Electronics SSNLF, -3.07% In the past it had a bigger weighting toward basic-industry, mining and commodity-oriented companies, which carry lower valuations than tech. “The quality of opportunities has improved over the past five years,” notes Wilson. “There has been a shift from heavy industry and commodity-driven growth to more interesting business models. The tech industry has become more important.”
4. There will be no contagion from TurkeyEmerging market currency declines in 1997-98 sparked an EM debt crisis that hit U.S. stocks hard. So worries about Turkey are understandable. But a repeat is probably not in the cards, says J.P. Morgan economist David Hensley. Trade with Turkey is relatively small. Banks outside Turkey are on the hook for about $265 billion in loans, mostly held by EU banks. But European banks have enough capital to avert a crisis.
Seven ways to get EM exposureThe Thornburg Developing World Fund THDIX, +0.46% that Wilson manages is one way to go. It has 86% of its assets invested outside the U.S., and it is on a roll because it outperforms competing funds by 1.7 percentage points in the past year, according to Morningstar. Wilson also singles out these two companies that trade on U.S. exchanges as American depositary receipts (ADRs).
Azul AZUL, -6.88% : As the name suggests (“blue” in Portuguese), this Brazilian airline was started by JetBlue Airways JBLU, -1.81% founder David Neeleman.
Azul is a regional airline in underserved markets that previously had no access to air travel. This makes it a play on the poor infrastructure in Brazil. The airline flies people to major hubs and air routes.
So far, it doesn’t have a lot of competition, and it may stay that way since the local markets Azul serves are not huge. As a niche player, Azul has pricing power to offset increases in fuel costs, or the hit to margins from the weakening Brazilian currency, says Wilson. (Some of Azul’s costs are in dollars.) The airline is improving margins by upgrading its fleet. It will also benefit from shipping deals with the Brazilian post office and Amazon.com AMZN, +1.14%
ICICI Bank IBN, +0.10% : ICICI Bank is a play on the growth of consumer banking in India, as more people earn more. This means they will buy more financial products like insurance, brokerage services and asset-management services. India also recently took large denomination notes out of circulation, which makes it harder to do large transactions off the books in cash. This is driving demand for banking products like savings accounts, checking accounts and mutual funds.
“ICICI Bank is one of the strongest consumer and deposit franchises in India,” says Wilson. “It has excellent consumer-facing franchises it is not getting credit for.” Why not? The bank has a lot of bad loans to businesses. But it is in the process of cleaning up its balance sheet, and it has the earnings power to get this done, believes Wilson.
Investors are not so sure. That’s why this bank trades for about one times book value, if you subtract the value of the shares of publicly traded subsidiaries it carries on its balance sheet. Retail banks typically trade for two or three times book value, so Wilson thinks ICICI Bank stock could double or more.
For emerging market exposure, also consider the four largest exchange traded funds (ETFs) in the space: Vanguard FTSE Emerging Markets ETF VWO, +0.60% iShares Core MSCI Emerging Markets ETF IEMG, +0.71% iShares MSCI Emerging Markets ETF EEM, +0.79% and Schwab Emerging Markets Equity ETF SCHE, +0.70%
Is it time to put money in Turkey? Maybe not. The government there has pursued high-growth, simulative policies for years. That brought growth. But also high inflation, which contributed to the currency decline that set off the current crisis.
To solve this problem, Turkey probably needs to sacrifice growth and use higher interest rates and government spending cuts to bring down inflation. Will it? “This could very easily be contained, but so far the government has not taken the necessary steps,” says Wilson. “They are not taking the concrete actions that I think the market needs to see right now.”
That suggests further weakness in the Turkish lira and the iShares MSCI Turkey Investable Market Index Fund TUR, +0.23% ahead. “What we learned from watching the Greek crisis is that if you don’t get ahead of these things aggressively, they can be a lot more painful than they need to be,” says Wilson.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter, Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.
