Emerging market equities had a great 2017 and they still looked relatively cheap at the beginning of this year. That relative cheapness - especially when compared to the US - meant emerging market stocks were close to being a 'consensus trade' six months ago. When just about everyone is positive on a stock or sector, that's often a good time to get nervous and that's certainly been the case for emerging markets in 2018.
The MSCI Emerging Markets Index is down 18% since its peak in late January and there may be further falls to come. The falls have been triggered by concerns about debt, Trump trade wars, and the rising dollar. Currencies have been a problem for emerging markets in the 90s and before, so it's understandable that many investors are nervous about any signs of trouble in this area. The worry is that as emerging market currencies fall, the value of corporate debt rises which puts pressure on business and the economy leading to further currency falls. Not great.
Argentina and Turkey are the countries that have provoked the most worry with short term interest rates reaching 40% in Argentina last month as concerns about the Argentine peso heightened. (An IMF bailout of Argentina has now brought rates down somewhat.)
Positive case
However, analysts at Research Affiliates are positive on emerging markets and think prices have fallen too far. The analysts have looked at external debt, foreign exchange reserves and the current account trade and investment balance across emerging market countries, and the overall picture is pretty positive.
Countries that comprise 60% of the value of MSCI Emerging Markets index face 'little if any risk of a funding crisis', according to Research Affiliates. These countries include the biggest beasts in emerging markets - China, India and South Korea. Overall, the analysts argue that emerging market economies are much more stable than they were 20 or 30 years ago, and that should reduce the risk of investing in these markets. Granted, emerging markets are still riskier than more developed markets, but that extra level of risk is very well reflected in current emerging market valuations.
Research Affiliates also argues that emerging markets are cheap using a wide range of stock market metrics. These include CAPE (cyclically adjusted price earnings ratio), price-to-book and price-to-sales ratios. The CAPE ratio probably makes the most persuasive case for emerging markets stocks - the US market currently has a CAPE ratio over 30 whilst emerging markets are around 15.
It's also important to stress that the long-term case for emerging markets investing hasn't gone away. Economies such as China and India are likely to deliver faster economic growth over the next 20 years compared to the US or Europe, and that will probably be reflected in share prices. The story of China becoming a much more consumer-led economy has a long way to run, and there are plenty of opportunities for ambitious Chinese companies to service the fast-growing Chinese middle class.
How to invest
If you want to invest in emerging markets, ETFs can be a great way to do it. Their big advantage is cheapness. For example, the MSCI Emerging Markets UCITS ETF (XMME) has an ongoing charge of just 0.2% a year which is much cheaper than the leading active emerging market funds. You can find out more about emerging market ETFs in this article.
