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For a decade-plus, international stocks confounded clients, consistently lagging domestic equivalents. Emerging markets equities are certainly part of that scenario.
That's disappointing for myriad reasons, not the least of which is many clients were led to believe the rapid rates of GDP growth in many developing economies would translate to superior equity market returns as the case for much of the earlier part of this century.
Indeed, there have been spells of emerging markets, particularly individual countries, topping domestic stocks, but those periods are often brief and rarely sustained for notable time frames. Consider this. From 2016 through 2021 – six years – the MSCI Emerging Markets Index beat the S&P 500 just once on an annual basis – in 2017.
With a track record like that, it's almost easy for advisors to steer clients away from broad-based emerging markets funds, active or passive. It's up to advisors to decide whether or not that's the proper course of action, but it very well could be today.
Valuation Doesn't Really Matter
Valuation has long been a cornerstone of the pro-emerging markets argument. As in stocks in developing economies are less expensive than in the U.S. That's true and it's been the case for some time, but so are a lot of ex-US markets. In other words, emerging markets aren't special because they're inexpensive relative to the U.S.
Matthew Bartolini, head of SPDR Americas research, confirms that emerging markets stocks are cheap, but there several other issues that indicate the class should be kept on ice for now. Those include dismal sentiment.
“The ratio of analyst upgrades-to-downgrades for 2022 Earnings-per-Share (EPS) growth has been below one (meaning more downgrades) for the past two months,” notes Bartolini. “Out of the four markets, EM is the only segment with a ratio below one. It also has had the lowest ratio every month for the past 11 months. It’s quite clear earnings sentiment is weak in the region – perhaps why relative valuations are so low.”
The broader EPS outlook of 5% growth for emerging markets trails the S&P 500, domestic small caps and the MSCI EAFE Index. That's certainly weak sentiment, but wait. There's more and it's not appealing, either.
“Weak returns weak and poor fundamental sentiment make momentum metrics unattractive for EM. Across nine different screens for momentum, time-series, cross-over, and continuous (i.e., frog-in-pan), emerging markets rank as the eighth- or ninth-worst market in seven of the nine categories,” adds Bartolini.
Inflation Problematic There, Too
Think again if you believe the U.S. is the only economy grappling with inflation. Plenty with the developing label are, too, and central banks in some of these countries eagerly raised interest rates last year. It's good those central banks are proactive, but most of those rate hikes caught market observers by surprise and they're concerned about economic growth.
“The average central bank rate for EM economies has been increasing over the past few months, reversing a downward trend from prior years,” says Bartolini. “In fact, 45% of EM central banks have hiked rates over the past three months.”
Bottom line: Between poor sentiment, weak earnings growth and inflation, that's simply too much for valuation to overcome, confirming, at best, emerging markets stocks deserve a wait-and-see approach.
Related: Leveraging Dividend Growth for Rising Rates Protection