5 Ways to Invest in Emerging Markets While They're Cheap

Investors are wondering how much more disappointment they can take from emerging markets. The MSCI Emerging Markets index, representing stocks in 23 countries, suffered losses in four of the past five calendar years and has plunged 31% since April 2015. And the pain may not be over, given the rash of problems facing the developing world. “The perfect storm that has hit emerging markets in the past two years has become even more perfect,” says Nariman Behravesh, chief economist at IHS Inc., a business consulting and forecasting firm.

Start with the slowdown in China. The world’s second-largest economy expanded by 6.9% last year, the slowest growth rate in a quarter-century. IHS expects the growth rate to decline to 6.3% this year and in 2017. “Slowing growth in China will by default slow everything else around it,” says Christopher Wolfe, a strategist at Merrill Lynch Wealth Management.

Plunging commodities prices are a huge problem. World industrial demand, particularly from China, has slowed at the same time supplies have increased. The IHS Materials Price Index is at its lowest level since December 2003, spelling disaster for such exporters as South Africa, Brazil and Russia—the latter two perilously close to depression. Because commodities are priced in dollars, producers get a double whammy, “first from falling demand and then from the currency effect,” says David Joy, chief market strategist at Ameriprise Financial.

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Currencies in troubled countries have been collapsing as confidence in their economies has flagged. The flip side is the strength of the dollar, which has climbed 25% against a basket of foreign currencies since June 2014. Cheaper currencies can help struggling economies by making exports more attractive. That’s one reason China has allowed its currency to depreciate. But the declines are also a sign that investors are cashing in their chips. The Institute of International Finance estimates that net capital outflows from emerging markets soared from $111 billion in 2014 to $735 billion last year. Look for the exodus to continue if the dollar continues to appreciate, as Kiplinger’s expects it to do.

On top of everything else, there’s a dangerous debt bubble forming. Borrowing, by both governments and the private sector, exploded in the developing world after the Great Recession. In China, the ratio of debt to gross domestic product has more than doubled since 2007, to 280% last year. Throughout the emerging world, “revenues and currency values are falling, and debt is becoming more onerous,” says Joy.

The problems are undeniable, but the key question for investors is whether stock prices already reflect them. The MSCI Emerging Markets index sells for 10 times estimated 2016 earnings. That compares with 14 for the MSCI EAFE index, which tracks stocks in developed foreign markets, and 16 for Standard & Poor’s 500-stock index. GMO, a Boston money-management firm, says that emerging-markets stocks are among the cheapest asset classes in the world. GMO believes they will, as a group, return an annualized 4% after inflation over the next seven years. GMO thinks emerging-markets value stocks—those that are cheap on the basis of such fundamental measures as price to earnings—could deliver 7% to 8% a year after inflation. By comparison, GMO expects U.S. stocks to lose 1.8% after inflation over the same period.

Investors with a long-term outlook should not ignore such a large and promising part of the global economy. And there are bright spots, even now. India’s service-driven economy hasn’t been slammed by the industrial slowdown and should log 7% growth this year. Mexico’s economy is well-diversified and will prosper because of its proximity to the U.S. Markets on Europe’s periphery—Hungary, Poland and the Czech Republic—could do well as the economies of developed Europe rebound. South Korea will benefit from China’s healthy consumer economy.

For now, the weight of the evidence demands a cautious approach toward emerging markets. Shave a little off whatever you consider a neutral weighting in your portfolio. For clients with moderate-risk portfolios (those with 50% of their assets in stocks), that means no more than 5% in emerging-markets stocks, says Merrill Lynch’s Wolfe.

Good Funds for Emerging Markets

Most investors are best off tackling this corner of the world with a professionally managed fund. A good choice is Harding Loevner Emerging Markets Portfolio (symbol HLEMX), a member of the Kiplinger 25. Another is JOHCM Emerging Markets Opportunities (JOEIX). The JOHCM fund's senior manager, James Syme, skirts the diciest markets in favor of India, South Korea, Taiwan and China. “Stocks like Taiwan Semiconductor or Kia Motors benefit from recovery in Europe and a strong U.S. economy,” he says.

Fans of exchange-traded funds might explore iShares Core MSCI Emerging Markets (IEMG), which offers a diversified portfolio, including small-company stocks, with low expenses. Another option is iShares MSCI Emerging Markets Minimum Volatility (EEMV), which tracks a portfolio of low-volatility stocks and lost just 12% in 2015, compared with nearly 17% for its diversified emerging-market peers.

Currency hedges can be counterproductive over the long haul. But investors who want to strip currency swings from returns in this strong-dollar climate should consider iShares Currency Hedged MSCI Emerging Markets ETF (HEEM).