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‘Compelling’ Case for Emerging Markets: USAA Expert

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The Federal Reserve may have cut its monthly bond-buying program from $85 billion to $35 billion, but you wouldn’t know it by watching emerging-market stocks.

Earlier this year, the emerging markets tanked with the Fed’s tapering. But since early February, EM stocks are up 16%, says Wasif Latif, head of global multi-assets for USAA, in a report issued Thursday.

They’re up more than 6% for the year. Some key countries “have far surpassed that average, led by India’s stock gains of more than 20%,” he points out.

Analysis done by USAA points to the investment case for emerging markets being compelling in both the short term and over the longer term, “particularly when compared to the world’s developed countries,” Latif notes. “For that reason, we have an overweight allocation to EM equities relative to the benchmark, while maintaining an underweight position to U.S. stocks.”

GDP growth estimates for 2014 have been reduced for EMs, the analyst note, but their pace of economic expansion “still far exceeds that of the U.S., Western Europe and Japan, and there’s nothing to indicate that this trend will be changing any time soon.”

Furthermore, the foundation of that economic growth keeps shifting.

“Whereas China was once content to be the factory for the world, it is now redirecting its production to meet a growing demand for goods and services at home,” Latif explained. “This powerful shift in emphasis from exportation to domestic consumption results from higher living standards and is not unique to China.”

As for EM companies’ fundamental valuations, they are “still attractive,” even after the rally over the past five months, he insists. It’s true that — on a cyclically adjusted basis — the price-to-earnings ratio for EMs relative to the P/E for the Standard & Poor’s 500 is well below average.

Earnings growth “has not been strong in EMs,” he adds, “but this growth has been driven by fundamentals rather than by share buybacks, as seen in the United States. Profit margins are low, so there is room for improvement there, and EM companies are not as leveraged as their developed-world counterparts.”

In addition, revenue growth has been “fairly decent” for those EM companies that focused on their domestic markets, and inflation remains “muted.”

“In all, there’s plenty to feel positive about when looking at emerging markets, and that upside could be further enhanced as economic growth picks up in developed markets,” Latif concluded.

USAA is not overweight non-U.S. developed markets, nor is it overweight emerging markets based on relative valuations. Instead, it says EM investments as attractive and offering “an interesting long-term prospect for growth.”

In addition, USAA’s cautious view of U.S. equities “remains unchanged,” he said. “we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are no longer cheap, and profit margins are near record highs.”

Check out Surprising Pick for High Safety, High Returns: Emerging Market Stocks on ThinkAdvisor.