Emerging Opportunities

This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.

Emerging-markets stocks and bonds are among the most volatile securities but have also delivered some of the best long-term returns for patient investors, as Karin Anderson noted in a breakout session at the Morningstar Investment Conference. Anderson, associate director with Morningstar Research Services, led a conversation on the growing opportunities in these dynamic markets.

Developing countries' economies and fiscal policies are improving, and more of these markets are making their way into broad global indexes. Emerging-markets stock funds have had among the highest inflows over the past 10 years, with much of that money going to passive vehicles in recent years. Meanwhile, there are five times as many emerging-markets bond fund options as there were a decade ago.

Penny Foley, portfolio manager of Silver-rated TCW Emerging Markets Income, noted that emerging markets are in an earlier stage of their business cycle than developed markets, and may have more room to run. After bouncing off the bottom of the financial crisis in 2009, many went into recession in 2013-2014, only coming out in 2016 after structural reforms that put many of the markets in good stead to thrive.

Anujeet Sareen, a manager on Silver-rated BrandywineGLOBAL Global Opportunities Bond, agreed that emerging markets are earlier in the cycle, and noted that developed markets haven't run their course, either.

"We are nine years from the global recession, so it seems like about time to run for the hills," he said. "But cycles don't end just because of old age. The Fed is still supportive. The European Central Bank and the Bank of Japan are very supportive."

That said, the U.S. stock market may be in the later stages of rising multiples, said Jeremy Schwartz, director of research with WisdomTree.

"Broad emerging-markets equity indexes are priced at 12 or 13 times earnings, which is a very wide spread relative to the S&P 500 at around 20 times earnings," he said.

Schwartz singled out Chinese companies Alibaba, Ctrip, and Tencent for off-the-chart growth rates but relatively restrained multiples. He noted that China will become an increasing stake in passive emerging-markets vehicles as MSCI adds A-shares to its indexes.

Also on the equity front, Schwartz discussed a trend toward custom benchmarks that strip out state-run companies that fall short on ESG concerns.

"The largest companies in a lot of emerging-markets indexes are state-run--about a third of the MSCI Emerging Markets Index," he said.

A significant portion of traditional China ETFs is made up of state-run energy companies, while a benchmark that excludes state-owned business focuses instead on technology and consumer names. Indexes that exclude state-run companies were top performers over the past year.

While it's been a rough year for emerging markets currencies, Sareen noted that "this is a dollar story," and is not indicative of undue risks. Instead, it spells opportunities, such as an 11% yield on 10-year Brazil government bonds, with inflation at 3% to 4%. In contrast, a 3% yield on 10-year U.S. bonds doesn't compensate for the inflation risk.

Sareen also believes that overblown concerns about NAFTA are creating opportunities in Mexican currency and bonds.

"Investors really dislike uncertainty," he said.

That said, 30-year bonds are yielding 8%, 400 basis points above inflation, and "the Mexican central bank has a lot of credibility." Meanwhile, the peso is cheaper today than it was when inflation was out of control.

Overall, the panelists saw ample reason to stay the course on emerging markets.

"From a fundamental perspective," said Foley, "We have a significantly better situation than in 2013."