Emerging Market Equities A Top Performer This Year

OCEAN CITY — Emerging Market (EM) equities have significantly underperformed those of developed markets since 2009. After continuing to lag in the first quarter, however, EM equities have recently overtaken the U.S. as the top-performing region for the year so far, returning more than 11%.

This move has come as a surprise to many, given the geopolitical concerns pervading the world — from Ukraine to the Middle East to Argentina’s default. Despite these events, flows into EM equity funds have picked up in recent months, reversing a year-long trend of outflows, indicating some of the bad news may be priced in. In the medium term, EM equities may continue to get a boost from valuations that are relatively attractive, especially compared to the U.S., and from various reform initiatives. Moreover, the trends of higher economic growth and favorable demographics justify the inclusion of this asset class in an investor’s portfolio over the long term.

EM equities overall currently trade at a valuation discount to their developed market counterparts. Valuations based on price-to-book ratios stand at nearly half those in the U.S. (U.S. equities trading at 2.8x book value, and Emerging Markets at 1.6x).

Countries that have executed reforms or are expected to do so have caught the attention and favor of investors. A notable example is India, where the election of a pro-reform government has unleashed a powerful 30% rally this year. Last month, Mexico’s president signed a historic energy reform bill that will allow foreign companies access to oil and gas fields in the country. This has the potential to make the oil industry more competitive and drive economic growth.

Investors, however, should bear in mind that the path to reform can often bring about unexpected volatility.

Expectations for reform in Russia, for example, have been overshadowed by fighting with Ukraine and ensuing sanctions, which have led to sharp selloffs in Russian equities several times this year. In China, despite reforms gathering pace, excessive leverage, housing overcapacity and corruption still threaten growth.

Good fiscal management and policy reforms should ultimately result in better business conditions, leading to an improvement in corporate profitability – key to a sustainable rally in EM equities. Thus far, fundamentals for EM companies remain weak. BCA Research, an independent research firm, notes that corporate profitability measured by return on capital and return on assets has been falling for several years. Since December, earnings expectations for 2014 have been revised more than 20% lower, according to BofAML Global Research.

Although the ratio has improved in recent months, negative earnings revisions for EM equities still outnumber positive ones.

Despite near-term volatility, the structural themes of higher growth and favorable demographics support the inclusion of EM equities in a portfolio’s long-term asset allocation. As BofAML Global Research Analyst Alberto Ades points out, growth in EM has been resilient this year, and aggregate GDP is expected to expand by 4.5% this year and 4.8% in 2015. According to the International Monetary Fund, emerging economies have grown almost five percentage points faster than developed countries over the past decade, and will likely continue to outperform. This gap may have narrowed in recent years, but in a world where liquidity is plentiful, global investment dollars will be attracted to incremental growth opportunities.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)