Emerging markets are poised to have a breakout year—and compared to U.S. equities these stocks are shockingly cheap

January 20, 2022, 10:00 AM UTC

As Baron Nathan Rothschild noted in a classic piece of investing advice, “The time to buy is when there’s blood in the streets.” Nowadays, red ink is washing over emerging markets (EMs), which haven’t been doing a lot of emerging lately. To devotees of the storied 19th-century British banker, that spells opportunity.

Two factors are at the root of the slowing economic growth and laggard stock prices of these tyro economies—which include the likes of Brazil, India, Malaysia, and Angola: the pandemic and a decelerating China, whose huge appetite for EM goods has diminished.

While nobody knows where the coronavirus is going, China is likely up ahead to rebound from its slump and whip out its order book again, to EMs’ delight. Meanwhile, investors may have a limited window to buy up EM stocks while they are cheap.

A drop in business from China, which has made a religion out of economic growth since the 1980s, is like cutting off oxygen for emerging economies. “China has been the main culprit” in EMs’ travails, says Hyung Kim, a portfolio manager at Kayne Anderson Rudnick, where he runs emerging-market investing strategies. “A slowing China, for instance, means less construction and less need for metals from Africa.”

China’s massive imports, according to the Macrotrends research firm, peaked in 2018 at $2.54 trillion, dipped by 2.8% in 2019, then by 4.8% in 2020, and likely some more last year. Goldman Sachs just cut China’s gross domestic product forecast for 2022 to 4.3% from 4.8%.

Why invest in EMs?

Before 2020 and the pandemic’s onslaught, EM nations’ bourses often logged double-digit returns. Emerging nations’ big plus is their potential for better economic expansion than in advanced economies.

Starting from a lower base, EMs have more room to grow. Further, their populations tend to be younger than in the developed world. That means improving productivity and a sizable cohort of consumers with swelling purchasing power. Additional bonus: EM stocks are not that closely correlated with U.S. equities, a Vanguard Investments research paper states.

Meanwhile, shares in these emerging economy companies are alluringly priced. For the iShares emerging market fund, the price/earnings ratio (P/E), which measures how expensive stocks are, is a thrifty 14. The S&P 500’s P/E is 21.

Many financial advisers recommend using mutual funds or ETFs to partake of emerging markets’ promise. Research firm Morningstar contends that funds’ diversification is best for safety. Buying individual EM stocks and bonds can be risky because researching them is often difficult.

The good news? A plethora of funds are available. Some cover the vast span of EMs, such as the iShares MSCI EM ex-China (EMXC). Though it logged just 8% last year (while the U.S.’s S&P 500 roared ahead almost 27%) the ETF is already up 3% in 2022. This fund, as the name implies, excludes China. (Even though it’s the world’s second largest economy, China technically remains an EM, owing to its large amount of rural poverty.). Other funds focus on particular investing themes, like SPDR S&P Emerging Markets Dividend (EDIV), for the payout-minded, and WisdomTree Emerging Markets ESG (RESE), offering environment-friendly exposure. BlackRock’s iShares, the largest ETF provider by both assets and number of funds, has products that cover specific countries, such as Brazil (EWZ) and India (INDY), as well as a couple devoted to regions: Asia (EEMA) and Latin America (ILF).

Not all EMs are created equal

At the moment, some EMs—especially those dependent on commodity exports—are facing more challenges than others. Take Brazil’s economy, which shrank by 3.9% in 2020, bounded back to a 4.9% increase in 2021, but is projected to expand by just 1.4% this year. The chief Brazilian goods sent to China are soybeans, oil, and iron ore. The situation also is muted in Angola (main export to China: oil). Its GDP lost 5.4% in 2020 and gained just 0.4% last year. The World Bank projects Angola will move up to 3.1% growth in 2022.

Things are looking better, however, in East Asia, which has become a manufacturing hub that serves many more places than China (which nevertheless remains the region’s biggest trading partner). Malaysia (electronic parts) saw its economy drop 5.6% in 2020, and recover a bit with a 3.3% increase in 2021; it may reach 5.8% this year, says the World Bank. India (iron ore, cotton) had a modest slowdown in 2020, to 4.0%, then went into the red by 7.3% in 2021, and should come back with an 8.3% rise this year.  

But a Chinese revival would improve things

If China turns itself around, a lot of impetus will be restored to emerging nations, analysts say. At the root of China’s downshifting growth rate is the Beijing regime’s desire to purge the excesses of overweening debt, choke off wanton speculation, and curb the power of the nation’s business elite (which ironically is responsible for much of the country’s economic prominence).

This antibusiness stance is not doing much for Chinese corporate health. Last year, the government fined e-commerce giant Alibaba Group Holding a record $2.8 billion to punish its purported monopolistic practices, and slapped the business with a batch of regulations. The company also agreed to spend $15.5 billion for Beijing’s drive to shrink China’s income inequality. The regime “wants to rein Alibaba in so they can control it,” says Jeff Grills, head of EM debt at Aegon Asset Management. Alibaba has announced lower expected revenue going forward.

In other words, much of the Chinese economic slowdown is a policy decision, which can be reversed or at least modified—through higher government spending, interest rate decreases, and other stimulus actions. And that bodes well for China’s resumed expansion, and eventually for the EMs that depend on it.

China’s supreme leader has every reason to juice the nation’s economy this year. The 20th Communist Party National Congress is in October, when President Xi Jinping aims to be anointed for a third term. “Xi wants the crown jewels and will feel pressure” to ensure that the economy has resumed its expansion, says John Mowrey, CIO of NFJ Investment Group, where he oversees EM investing.   

Numerous China observers expect a policy flip.  “Looking forward, we see very significant signs of a policy change in favor of a pro-growth phase in China,” write David Semple and Oksana Miller, of asset manager Van Eck Associates, in an analysis note. The upshot, they believe, is “the effect of heightened regulatory tightening that scared and confused the markets is diminishing.”

Before that occurs, though, heeding Baron Rothschild’s counsel about taking advantage of the bloodshed might make sense.

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