Research Affiliates' CEO, Rob Arnott, thinks emerging markets are a hat trick: An unusual three-way combination of low valuations, depressed currencies and strong momentum.
Mr. Arnott first made his recommendation for emerging markets back in January, and the average diversified emerging markets fund has gained 7.8% this year, and 17.8% since the February 8 low. Those strong gains are no reason to give up on emerging markets, he said.
The Shiller price-to-earnings ratio is the basis for Mr. Arnott's valuation argument. Created by Yale economist and Nobel Prize winner Robert Shiller, the Shiller PE ratio uses average inflation-adjusted earnings from the previous 10 years, rather than one-year trailing or one-year forward estimated earnings.
By that measure, emerging markets were trading at 11.2 times earnings, below the 13 times earnings during the 2008 financial crisis.
At those levels, Mr. Arnott projects a 7.5% return after inflation over the next 10 years.
Valuations in emerging markets went from euphoria to despair from 2007 to 2016, Mr. Arnott said.
"The narrative shifted from where emerging markets were going to catch up with the developed market — it was just going to take time — to the diametric opposite by 2015,” he said.
And countries don't have to become wonderful to send markets soaring.
“Brazil had a nearly 80% move this year,” Mr. Arnott said. “Was it because they went from corruption to the rule of law? No. It was because they took baby steps from right to wrong.”
Buying into markets when they are trading at a Shiller PE of less than 10 has had an average total return of 120% five years later.
“That's pretty darn good,” Mr. Arnott said.
The strong dollar, which has bedeviled most international funds, is also a positive for emerging markets. An unusually strong dollar means unusually depressed emerging-markets' currencies. “Emerging-markets currencies tumbled from 25% above fair value in 2011 to 30% below fair value in January of this year,” Mr. Arnott wrote. “Even after this year's rebound, they remain about 19% cheap to the U.S. dollar.”
While currencies are notoriously difficult to predict, Mr. Arnott thinks emerging-markets currencies could continue to rise back up to fair value or beyond.
The final hat in the ring: momentum. Chasing performance is generally a losing tactic. But following trends — which has a sell discipline — can be a successful tactic, Mr. Arnott argues. Removing the emerging-markets' 2015 free fall from their 12-month records will strengthen their 12-month momentum signal.
The economic news out of emerging markets is probably the least positive part of the forecast. Mr. Arnott said his business cycle forecast shows a 54% chance of an economic slowdown. But slowdown risks are down considerably from their 2015 level of 67% — meaning that, while the forecast isn't great, it's less bad than it was.
“Given recent price and economic momentum, we are reasonably confident the bear market in EM assets — five years long for EM equities and currencies, and three years long for EM local currency bonds — came to an end in January 2016, and the early stages of a bull market look to be well underway,” Mr. Arnott wrote.
He is also bullish on emerging-markets bonds, which currently yield more than U.S. high-yield bonds. The big difference: “Half of emerging-markets bonds are investment grade,” Mr. Arnott said.