Why emerging markets are the ‘trade of the decade’

Emerging market equities returned to form in 2016, but investors should not rush to take profits, according to a report by a US company that makes long-term investment predictions for various stock and asset markets.

Research Affiliates, which specialises in smart beta and asset allocation, has outlined three reasons why emerging market returns over the next decade will be ‘very attractive’, despite the rebound the market has enjoyed since the turn of the year.

According to the firm, the ‘very rare combination’ of cheap equity valuations, depressed currencies and positive momentum in equity prices and economic fundamentals will help fuel a bull market for the asset class over the next decade.  The report can be read in full here.

In January Research Affiliates described emerging markets as ‘the trade of the decade’, and it has not changed its view despite the recent rebound. The firm says on the Cape valuation measure, which compares a firm’s market value with its profits over 10 years, emerging market equities are trading at 11.2 times, lower than their financial crisis level in 2008 of 13 times. 

Rob Arnott, chief executive officer of Research Affiliates, notes in the report that with a 19 per cent rebound since the turn of the year, some investors might think they’ve missed the emerging market rally and it is now too late to invest. But according to Arnott, ‘they may want to reconsider’.

He adds: ‘Rather than rely on past averages to forecast future returns, we use a building-block approach that adds current yield, likely long-term growth in income, and some mean reversion in valuation multiples to create forward-looking returns.

‘This method indicates a 10-year real return for capitalisation-weighted emerging market equities of 7.5 per cent a year, and was as high as 9 per cent a year in January.’

Earlier this year in Money Observer’s June edition, our cover story highlighted that for long-term investors the emerging market regions had arguably become too cheap to ignore.

Furthermore, in September emerging market equities became the favoured investment area with our quarterly asset allocation panel, with all five panellists overweight the area.

But over the past month returns have cooled somewhat, following the US presidential election. President-elect Donald Trump’s protectionist stance, which includes the potential introduction of tariffs on imports from foreign companies, is viewed as a major headwind for the emerging market regions.

Arnott observes that the narrative had been that a Trump win would devastate global markets, but this has so far failed to play out. Moreover, he adds, it is quite possible that the narrative suggesting Trump will be awful for trade and wreck the emerging economies will also prove to be full of hot air.  

‘In any case, even with the mild correction in emerging markets since the election, trailing 12-month momentum is poised to improve, not erode: the free fall that occurred in December 2015 and January 2016 will be removed from year-over-year returns in the weeks ahead, which will serve to strengthen the 12-month momentum signal,’ says Arnott. 

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