If investors have indeed reached the point of “maximum pessimism” vis-à-vis emerging markets that Anthony Cragg, lead portfolio manager of the Emerging Markets and Asia Pacific Equities teams at Wells Capital Management, believes they have, then 2016 could be a better year for the asset class.
Emerging markets have never been so undervalued and so undersold as in 2015, Cragg says. Year-to-date outflows from emerging markets are approaching $60 billion and they have underperformed other markets to such an extent that it seems “there’s little more that could go wrong.”
There is room on the upside, though, and the Federal Reserve’s decision to increase interest rates by a quarter point could help in that regard.
A rate rise is testament to improving economic fundamentals, and for emerging markets, “a recovering U.S. economy isn’t bad news,” Cragg says. “In fact, it could even prove to be good news, so it’s important to look behind the hike itself.”
The Fed is expected to continue raising rates gradually — an approach that will benefit emerging markets, agrees Ben Rozin, senior analyst and portfolio manager at Manning & Napier Advisors. Most countries and currencies have suffered significantly from the rising value of the U.S. dollar over the past years, so “to the extent that the brunt of the dollar moves can be behind us, then perhaps the liquidity and outflow pressures emerging markets have been under since the Fed’s  Taper Tantrum can subside,” Rozin says.
Couple that with how cheap these assets are, and emerging markets equities could attract increased attention in 2016.
However, cheapness alone won’t suffice. Careful selection will be paramount, Cragg says, since fundamentally “nothing has changed,” and the big-picture issues that emerging economies have contended with over the past couple of years are still a reality.
Chief among them are commodity prices, which are still depressed. That, combined with a slowdown in demand for raw materials from China — the largest global consumer — has had a serious impact on the economies of commodity exporters, says Bryce Fegley, portfolio manager of the Saturna Global High Income Fund.
Fegley does not see any evident catalyst on the horizon for a commodity price rebound, which means countries like Brazil, South Africa and Indonesia — whose currencies, like many other emerging market currencies, also fell to record low levels in 2015 — are likely to continue facing tough times in 2016.
“China accounted for more than 100% of the increase in commodity demand from roughly 2005 to 2012,” Fegley said. “Now, the slowdown in raw material demand from China is something that I believe we are going to be living with for the next decade because there really is no other region in the world that can pick up the slack that China has left.”
Commodity exporters aside, most emerging stock markets are down (despite a brief rally in early December, the benchmark MSCI Emerging Markets Index is down more than 13% for the year), and in Brazil, companies like Vale, a metals and mining multinational, and state-owned oil company Petrobras, are so “bloated with debt” that there’s little chance they can “recover to their previous valuations,” Fegley says. Brazil is also riddled with political troubles — a corruption scandal involving high-level corporate executives and government officials, deep public dissatisfaction with the administration of President Dilma Rousseff — as is South Africa, where President Jacob Zuma changed his finance minister three times during the course of one week.
And after such events as the November terrorist attacks in Paris and heightened tension between Russia and Turkey, geopolitical uncertainties are a top worry for many emerging market investors.
That’s why selectivity – between regions, countries and companies – will be key in 2016.
For Frederick Jiang, portfolio manager of Ivy Emerging Markets Equity fund, the best emerging market opportunities lie in what he calls the “new economy” sector — areas fueled by increasing consumption, an important underlying driver for most emerging economies.
One of his top holdings is CAR Inc, a Chinese car rental company.
“Rental cars is a sunset industry in the U.S., but in China it’s just starting out and the stock is up 30% this year,” Jiang says.
He even owns the stocks of convenience stores in Brazil – retail outlets that, he says, are rapidly replacing Mom-and-Pop-style bodegas and are proving hugely successful in a market that has practically zero appeal for most investors at this time.
Brazil, though, could become interesting if Rousseff steps down as president or cuts a deal with the opposition, which could result in more market-friendly policies and greater incentives for private capital, both domestic and foreign, Rozin says.
In general, Rozin believes that countries that continue to enact serious structural and market reform are good places to invest, and India tops his list.
“The Indian market is down year to date and because the thrust of policy is positive, we are looking to add to our exposure there,” he says. “There is better coordination in the government between ministries and that is positive from a medium-term perspective. India also benefits from lower commodity prices and its current account deficit has come down significantly, as has the inflation rate.”
— Check out 10 Reasons Not to Dump Emerging Market Stocks: GMO’s Inker on ThinkAdvisor.