Why EM stocks are doing well

Stocks of emerging markets like the Philippines are in favor this year. In January, the emerging market exchange traded fund (ETF) IShares MSCI Emerging Market (EEM) was up 9.1 percent. In contrast, the S&P 500 increased by only 6.2 percent.

There are compelling reasons why emerging market stocks deserve to outperform US stocks.

China, which is one of the biggest emerging markets, just exited from its zero-covid policy. Because of this, its GDP growth is projected to accelerate to 5.1 percent in 2023 from 3 percent in 2022.

The Philippines’ GDP growth is also expected to remain strong at 5.5 percent this year, despite the projected slowdown in the global economy, being a domestically-driven economy.

In contrast, US GDP is projected to grow by only 0.5 percent this year. The number could even surprise on the downside as the Fed continues to tighten despite growing signs of disinflation.

Expectations that the Fed will soon pivot is also causing the dollar to weaken, which is beneficial for EMs. Aside from boosting dollar returns of foreign investors owning EM stocks, a weaker dollar helps reduce inflation in EMs by pushing down the cost of imported commodity products such as oil.

EM stocks have also massively underperformed US stocks during the past 10 years. For example, from 2012 to 2022, EEM was down 14.5 percent while the S&P 500 was higher by 169 percent. Consequently, foreign investors are heavily underweight in EM stocks.

EM stocks are also very cheap. For example, the PSEi Index is trading at only 15x 2023 P/E, well below its 10-year historical average P/E of 18X. In contrast, the S&P 500 is still trading at 19X 2023 P/E, above its 10-year historical average P/E of 18X.

Underinvestment means significant room for foreign fund inflows while cheap valuations provide more substantial capital appreciation potential.

Although EMs are fundamentally better compared to the United States, the main concern is the ability of EMs to decouple from US equities if the United States suffers from a bear market. After all, history has shown that every time the United States sneezes, everyone catches a cold.

As mentioned earlier, there is a risk that the US economy will enter a recession later this year due to the possible overtightening by the Fed to control inflation. In the past, the US market only reached a bottom after a recession is announced and the Fed starts to cut interest rates.

Only time will tell if EMs including the Philippines can decouple if the United States suffers from a bear market. However, if the Fed successfully engineers a soft landing of the US economy despite its aggressive tightening policy, EMs will most likely outperform. Note that during the 10-years prior to 2013, EMs and Philippine stocks consistently outperformed the S&P500.

Rather than completely staying away from EMs and Philippine stocks because of the risk of a bear market in the United States, investors can just be more conservative. Manage your risk by limiting the size of your investment so that you can afford to hold on to your stocks even if prices become volatile. Moreover, be disciplined and only buy stocks that are more liquid and are still trading at attractive valuations. Finally, keep some cash or dry powder so that you can take advantage in case EM stocks are sold down to very attractive levels because of a US bear market. INQ