Emerging-markets (EM) equities staged a spectacular comeback this spring. Still, investors need not be afraid that they might be late to the party: the periods of EM outperformance (or underperformance) over the developed markets tend to be quite long. The most recent downswing (in relative terms) took place between 1994 and 1998. Afterwards, the emerging markets boomed for twelve long years, before the current downtrend (as measured in U.S. dollars) got underway towards the end of 2010. Unsurprisingly, many investors were itching to invest and thought that the ideal moment to do so had come by end-2015. After all, things could hardly get any worse, could they? And the situation did indeed improve in the spring. The U.S. dollar depreciated against other major currencies, the Fed became more cautious again after its first rate hike, and commodity prices recovered. In turn, EM exchange rates stabilized. Institutional investors, who had been overweight Europe and Japan at the expense of the emerging markets, quickly adjusted their positions. Prices rose by almost 25% from their low in mid-February.
We, too, changed our stance on the emerging markets to neutral in March, as their risk-return profile improved in comparison to sluggish developed markets. Their valuation discount versus U.S. equities, as measured by the price-earnings ratio, amounts to about 35%. While diversification remains key in the emerging markets, Asia and Brazil jointly make up three quarters of the total market capitalization. Asia remains our favorite EM region – and not just because the Asian emerging markets, being net commodity importers, should benefit from low commodity prices in the medium term and favorable demographic trends in the long run. In addition, the Indian government continues its reform efforts, Beijing has stabilized the Chinese economy for now and South Korean exporters could benefit from Japanese yen appreciation. In Latin America, short-term dynamics appear attractive. Here, earnings expectations for 2016 have improved since mid-February, whereas they have only stabilized for Asia. The possibility of a political turnaround in Brazil is fuelling investor speculation. Still, we believe the current degree of optimism is excessive, as the country is faced with major economic-policy challenges. Overall, we think it is too early to expect a sustained upswing of EM equities. Still, they should have passed their trough, and we believe moderate investments in EM equities offer good diversification opportunities away from the developed markets.