Emerging-Market Stocks Lagged — Here’s Why They’re a Buy

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Emerging markets aren’t boring or scary – if they can provide returns. Well, they lagged last year and now’s the time to buy them, UBS Global Wealth Management says.

“Emerging-market equities are set to outperform,” says the firm’s CIO of global wealth management, Mark Haefele.

The MSCI Emerging Market Index underperformed the global market last year, rising 13%, or half the MSCI World Index's gain. But UBS makes a case for EM stocks beyond the numbers.

First, the global market won’t create a high bar for returns this year. "We expect overall equity returns to be lower this year than last and … economic conditions and valuations to favor emerging-market equities,” Haefele wrote in a note.

U.S. stocks have risen fiercely in the past year, pricing in both a better-than-expected economic outlook for 2020 and continued lower interest rates.

"The benefits of a phase one [U.S.-China] trade deal should accrue more to” Asia and China, Haefele said, as China has been hurt the most by the trade war, Haefele said.

China relies heavily on exporting to the U.S. For their part, U.S. companies must absorb or raise prices due to the Trump administration’s tariffs and also have invested less as a result of the uncertain economic conditions the tariffs created.

UBS also forecasts that the gap between emerging-market GDP growth and developed-nation GDP growth to widen to 3.5 percentage points from 2.5 points in 2019. That favors emerging markets, since those economies usually grow faster than those of developed nations because they are smaller – though they pose more market, sometimes deriving from political risk.

The World Bank said this month it’s looking for EM GDP growth of 4.3% in 2020, up from 4.1% in 2019. The U.S., for reference, grew around 2% in 2019 and many experts expect growth of around 1.3% to 1.7% in 2020.

So what about valuations?

"Price-earnings multiples in the U.S., other developed markets and emerging countries aren’t extreme, but they are above 10-year averages and near their early 2018 peaks,” Haefele said, echoing many Wall Street analysts. "That leaves earnings growth as the primary return driver this year.”

The S&P 500, which has an average multiple of just under 19, is expected to see earnings growth of roughly 5% for the year, while emerging-markets earnings growth is seen around 10%, Haefele notes.

EM equities trade at just above 12 times next year’s earnings. More important, the valuation gap between EM and the S&P 500 is wider than it has been historically, Haefele says. The average stock in the S&P 500 trades at a p/e multiple half again that of the average EM stock. In mid-2012, that difference was about 40%, according to data from Yardeni Research.

EM equity — both institutional and retail — seem positioned for inflows as well. "A lot of long/short equity managers that focus on very-large-cap U.S. stocks are losing money. There’s a rotation into long/short equity strategies that focus on small-cap stocks [and] emerging markets,” Don Steinbrugge, hedge-fund manager and founder of consultant Agecroft Partners, told TheStreet.

EM "has suffered cumulative fund outflows in recent years, so its share in global mutual fund assets is low at 7% compared with 9% historically,” Haefele says.

UBS is overweight emerging-market stocks.