It is no secret that emerging markets come with a high-risk, high reward tag. According to the World Bank, China and India saw GDP growth of over 6.5% each in 2017, while developed markets like the UK and the US were hovering below 3%. Canada saw its GDP grow 3%.
But on the other hand, emerging market stocks have been beaten down this year. The S&P/TSX Composite index is down over 4%, year to date, while the S&P 500 is up 7.8%. But the Morningstar Emerging Markets index is down over 12% year to date.
Does this mean that emerging markets are a good bet right now? At Morningstar, we recently made the case that growth investors cannot ignore India, or really, emerging markets in the hunt for long term growth.
But what can we expect from emerging markets in the short term? Volatility, says Jean-René Ouellet, senior analyst at Valeurs Mobilières Desjardins.
“The magnitude of the drawdown has been smaller than it has been in the previous bear markets, so though these markets are cheaper now, it is not as though they are cheap”, Ouellet says, adding that he believes that emerging markets could still see a significant decline going ahead.
Over the next few months, up until the first half of 2019, Ouellet believes there could be further declines as pressures from a stronger US dollar and the Federal Reserve raising rates affects emerging markets.
“We could see valuations become attractive in the first half of 2019, and we will buy when these markets trade at an at least 20% discount to developed peers”, he says.
Among emerging markets, Ouellet likes Asia better than others.
China and India: Long term gains, short term pains
Ouellet points out China’s focus has moved from infrastructure and building to domestic consumption, and as its focus becomes more internal, this will negatively impact other emerging markets. So he likes markets like Brazil, South Africa and Latin America less, as a drop in Chinese demand for materials will negatively impact growth in these countries.
“Having said that, we expect the reforms domestically in China to continue, which will lead to some short-term pain. We want to wait out this short-term pain and choose to stay on the sidelines for now”, he adds.
He notes that India is the market with the greatest long-term potential, but it has significant short-term challenges, including a large amount of external debt that needs to be repaid in US dollars, as well as a reliance on oil imports. He adds that in the long-term, he sees significant potential in India.
How should you invest?
For investors who want to look at emerging markets and benefit from the China consumption story, investing in an exchange traded fund that focuses on emerging markets, and Asia in particular, would make sense.
“Two ETFs that we like are BMO Low Volatility EM Markets Equity ETF (ZLE) and iShares MSCI Emerging Markets Asia ETF (EEMA)” Ouellet says.
In terms of specific stocks, Ouellet looks for size, quality, barriers to entry and difficulty to replicate the companies.
“Two that we like are Tencent (TCEHY) and Alibaba (BABA). These companies are the Google and the Amazon of China” Ouellet says.
He points out that the market cap of both have fallen, and both companies are down from 50-60 times earnings to around 35 times forward earnings, and though they are still more expensive than their American peers, they are good companies with great balance sheets and low debt.
“I am watching them closely and may add them to my portfolio in 12-18 months. If I was to give you $200 billion tomorrow morning, you still would not be able to create these companies, and that is where their value is. The only reason I don’t own them now is because I don’t think they are cheap enough – it’s about the valuation”, Ouellet says.
For those looking to take advantage of emerging markets right here in Canada, Ouellet likes Bank of Nova Scotia (BNS).
“Every time there is pressure on emerging markets, this stock falls as well. Nearly 50% of its operations are outside Canada, mainly in Latin America, so if you want to take exposure to emerging markets without leaving the comfort of your own back yard, this is a stock to consider”, Ouellet says, adding that Bank of Nova Scotia has more than 4% dividend yield, is trading at close to 10 times forward price to earnings, and looks good from a valuation stand point as well.
