Despite a “really lousy second quarter,” emerging market stocks remain relatively attractive in global portfolios, according to Ben Inker, who heads GMO’s asset allocation team.
In the latest GMO quarterly newsletter, Inker explains that at their current valuation, following a second quarter selloff, emerging market stocks are “the most attractive asset … by a large margin. … Emerging equities are cheaper than they were three months ago and history shows that when these assets are cheaper they perform better over time.”
In the longer term, “valuation is much more predictive of returns for emerging than momentum,” writes Inker.
In the meantime, however, emerging market stocks can be volatile – they are “one of the riskiest risk assets out there,” says Inker — and they were hammered on Monday as the financial crisis in Turkey intensified.
The iShares MSCI Emerging Markets ETF (EEM) fell 1.4% on Monday, while the iShares MSCI Turkey ETF (TUR) plunged 11% following Donald Trump’s announcement that was doubling tariffs on metal imports from Turkey.
Asked whether he stood by his outlook in light of Turkey’s problems, Inker said his “position has not changed. Turkey is about 1% of the MSCI Emerging Index and has long screened as just about the most vulnerable country on our credit cycle work. Part of investing in emerging markets is understanding that idiosyncratic challenges hit different countries at different times, often creating interesting investment opportunities.”
Valuations are not the only reason Inker favors emerging markets. He also expects the “underlying fundamentals for emerging stocks will grow solidly over time,” namely dividends and capital. He assumes that the sum of dividends and per share growth in capital will be roughly 6% after adjustments for inflation and return on economic capital will average 6% over time.
Inker, however, is not blind to risks in emerging markets including continued strength in the dollar which makes it harder for emerging market economies to repay dollar-denominated debt, increased inflation pressures and local and foreign investors fleeing local emerging markets during sharp downturns. He notes that emerging market stock prices and emerging market currencies tend to move in the same direction unlike stocks and currencies in developed markets, which is “arguably the reason why emerging markets are more volatile than developed markets.
Inker writes that investors are right to be concerned about the impact of escalating trade tensions on emerging markets – “the more the topic ‘trade war’ gets mentioned on Google the worse the performance for emerging markets” – but perspective is needed.
While tariffs are “probably worse for emerging market companies than developed market companies given their place in the supply chain … it seems likely that the impact of the U.S. imposing tariffs on the rest of the world and the rest of the world responding in kind is likely to be worse for the U.S. than everywhere else.”