Big gains attract new money to emerging markets, but should investors stay?

Emerging markets​ have offered all the thrill of a 10-foot slide into a cobra pit for much of the past decade. But right now, emerging-market stocks are in a sweet spot: They have low prices, lots of momentum and a flood of new cash pouring in. If you’re getting your clients into emerging-market funds and ETFs now, however, you’d better be sure to prepare them for the inevitable downturn. It may not come soon, but it will come. Hence, the advantage of emerging markets goes to those who can truly be long-term, buy-and-hold investors.

The MSCI Emerging Markets Index has lost 0.5% a year the past 10 years in U.S. dollar terms, versus 7.2% average annual gains for the Standard & Poor’s 500 stock index. The global financial crisis gave emerging markets a big shove downhill. The so-called “taper tantrum” in 2013 — a spike in Treasury yields spurred by fears of the end of the Federal Reserve’s quantitative easing program — kicked them down again, as did later worries about China’s economic slowdown.

The result: very cheap valuations in emerging-markets stocks.

“There was a time about 18 months ago where the Shiller P/E of the entire emerging-markets asset class was below 10,” said Chris Brightman, chief investment officer at Research Affliates. “Valuation is a lousy timing tool, but history instructs that if something is that cheap, you’re likely to have extraordinarily good returns over time.” (The Shiller P/E, named after its creator, Nobel-prize-winning Yale professor Robert Shiller, looks at inflation-adjusted earnings from the previous 10 years in relation to prices.)

After big gains in 2016 and 2017, emerging markets in the aggregate are not as cheap as they were 18 months ago, but they are considerably cheaper than U.S. stocks. The current Shiller P/E for the S&P 500 is 30.24, higher than it has been at any time except immediately before the Great Depression. Emerging market stock valuations “are no longer at the extraordinarily cheap prices that you had in January 2016, but they still remain much cheaper than anywhere else,” Mr. Brightman said.

(Watch: How advisers can better communicate the risks and rewards of investing in emerging markets)

The rise in stock prices in emerging markets has been broad-based: Of the 24 emerging markets tracked by MSCI, only three — Qatar, Russia and Pakistan — have shown losses. Greece has jumped 49% this year, China is up 31% and South Korea is up 29%. It’s not just a blip after a punk period. “Earnings growth has met and exceeded expectations,” said Chuck Knudsen, vice president at T. Rowe Price Group Inc. “This is a sustainable, multi-year rally that’s in about the third inning.”

Big price gains attract lots of new money. To small markets, such as many emerging markets, that flow of money is like filling a Coke bottle with a firehose, sending prices soaring further. So far this year, an estimated $6.7 billion has flowed into emerging-market stock funds and ETFs, according to Morningstar, second only to flows to diversified international funds.

Much of those new flows are coming from ETFs, said Mark Mobius, executive chairman of the Templeton Emerging Markets Group. The funds typically follow an index, which means that the most money flows into the largest companies. “The big get bigger,” Mr. Mobius said. Flows can also boost a single country’s market dramatically. When MSCI decided to start including Chinese A shares in its emerging-markets index, money from around the world rushed into China. “China became much more dominant,” Mr. Mobius said.

THE CHINA FACTOR

China, which stands at about 30% of most emerging-markets indices, has been one of the driving forces in emerging markets this year. Just as slowing growth in China bedeviled emerging markets in 2014 and 2015, its recent recovery has boosted them. Just this month, for example, China announced gross domestic product growth of 6.7%, up from 6.5% in the first quarter. “When we look at China, we look at the transition from fixed assets and heavy industry to a consumption-driven economy,” said Casey Preyss, portfolio manager for the emerging-markets growth and emerging-markets small-cap growth strategies at William Blair & Co.

Growth in the Chinese consumer class has grown from first-tier cities, such as Beijing and Shanghai, to smaller cities, which still have millions of people. “The focus is on infrastructure build-out there: toll roads, subways, water systems,” Mr. Preyss said.

Furthermore, the so-called “ghost cities” are starting to become lands of the living. Property inventories have fallen from an average 40 months down to 14 months,” Mr. Preyss said.

Much of that consumer-driven economy has revealed itself in internet-oriented stocks, as the Chinese have discovered the pleasures of shopping from home and home delivery. “Four stocks — Samsung, Alibaba, Tencent and Taiwan Semiconductor — account for 30% of emerging-markets gains,” said Chad Cleaver, co-manager of Driehaus Emerging Markets Fund (DREGX). “We’re optimistic on tech companies, but at this point, earnings delivery becomes more important.”

Westerners often discount the Chinese ability to stick to a long-term plan, said Mr. Mobius. To the Chinese government, it’s not a quarterly sprint to GDP growth, but a hundred-year marathon. “It’s a planned economy, and they are able to control disasters better than we are in the West,” he said.

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China may be the most important emerging-market economy, but it certainly isn’t the only one. India, too, is working on improving its middle class with a new housing initiative, which means good growth prospects for lenders. “Mortgage penetration is 9% in India, versus 60% to 80%,” said Mr. Preyss. Similarly, just 10% of the population in India and Indonesia have cars or motorcycles.

And Brazil, which has become synonymous with political scandal, has been crawling out of a severe recession, which should be good for financial services companies there, said T. Rowe Price’s Mr. Knudsen. While government lending is sluggish, private banks have been stepping in to fill the void, he said.

LONG-TERM OUTLOOK

That trifecta of valuations, momentum and liquidity has convinced many respected firms, such as Research Affiliates and GMO, to enthusiastically endorse emerging markets for long-term investors. GMO, for example, projects that emerging markets will rise at a real rate of 2.9% a year the next seven years, the highest of the 11 asset classes in tracks. Research Affiliates puts the 10-year real growth rate at 6.8% annually for the next 10 years.

All well and good. But the problem with emerging markets is always its volatility. Convincing clients to buy now, while emerging markets are hot, won’t be hard. But getting them to stay during the inevitable downturn won’t be easy. The S&P 500 has fallen by 20% four times since 1990; emerging-markets countries have fallen more than 20% an astonishing 22 times in the same period. While the long-term benefits of emerging markets are fairly clear, advisers have to have a strategy to keep investors in those markets through good times and bad.

“There’s no way you’d want to underplay the risk in emerging markets,” said Research Affiliates’ Mr. Brightman. “Without question, it’s one of the riskiest things you can invest in.” A decline in U.S. stocks, for example, would certainly drag emerging markets down. So would a sharp rise in interest rates, which the emerging markets’ reaction to the taper tantrum proved. And a trade war with the United States could also put the kibosh on investors’ enthusiasm for emerging markets.

REBALANCING

For advisers, the best defenses are honesty about the volatile nature of emerging-markets stocks, and a commitment to rebalancing periodically to keep risk in check. If you’re going to put an investor in, say, Vanguard Emerging Markets Index, you should mention that the fund’s maximum drawdown from peak to trough in the past three years has been a 29.7% loss, according to Morningstar.

Keeping emerging markets part of an overall asset allocation is important as well — which means selling when the funds have done better than expected, and even harder, buying when they plunge. Should you do it today? “This is a wonderful time to diversify,” said Mr. Brightman. “Many leading endowments now allocate equally between the U.S., developed markets and emerging markets. It’s time to move towards that equity allocation.”

This article has been updated to indicate that Casey Preyss is a portfolio manager for William Blair & Co.