Emerging Markets Are a Buy

An article in Fortune reports that, while many including such finance experts as Jeremy Grantham of GMO, Mark Mobius and Rob Arnott of Research Affiliates sing the praises of emerging market stocks, “to commonsense civilians and other skeptics, they look and feel like a trap. Who’s right?”

The article outlines some of the risks and opportunities inherent in EM:

By wagering on China, Mexico and India, investors are “embarking on a potentially lucrative but almost certainly bumpy ride.” The article notes that the decline in EM in 2018 was triggered by the Fed’s tightening and the rise in trade tensions—factors which, in turn, slowed down EM growth rates and led to fear of a “meltdown” and funding crisis like the Asian debt crisis of 1997.

Those bullish on EM say that the risks are exaggerated, that a nation must be struggling with huge foreign debt, low foreign reserves and a trade deficit to be in real trouble. Further, the article notes, even when EM economies slow down, “they still grow faster than their grind-it-out, mature-economy counterparts.”

Despite the volatility, both Research Affiliates and GMO expect higher returns going forward in EM compared with U.S. stocks. The article reports that “both point to a gap in valuations that’s unjustified by fundamentals.” They say the best metric is the CAPE (cyclically adjusted price-earnings ratio) developed by Yale economist Robert Shiller, which according to Rob Arnott shows that today EM stocks are 60% cheaper than U.S. stocks.

The article cites comments by Chris Brightman, chief investment officer of Research Affiliates, who believes that emerging market stocks should return around 10% annually over the next decade and, by contrast, U.S. stocks will hit investors with average annual losses of 3.2% through 2025.

But those “rich emerging-market returns come at a price,” the article concludes. According to Research Affiliates, EM stocks are 50% more volatile than U.S. equities. But GMO’s John Thorndike says braving the storm is worth is. “The great thing about cheap,” he says, “is that as an investor, you don’t need anything great to happen. You just need a lot of bad things not to happen.”