Market Extra: Emerging-market stocks look poised for a comeback after a difficult decade. Here’s what U.S. investors need to know.

The iShares MSCI Emerging Markets ETF
EEM,
which tracks the widely followed MSCI Emerging Markets Index, fell 4.1% during the quarter ended in September, outpacing a 3.7% decline for the S&P 500
SPX,
the deeply liquid U.S. benchmark. Both benchmarks endured their worst performance in a year.

It is just the latest chapter in what has been a decade of persistent underperformance during both good times and bad. The EM ETF fell 22.4% amid the global equity-market rout in 2022, compared with a 19.4% drop for the S&P 500, FactSet data show.

But while the selloff in Chinese stocks has dominated headlines this year, some corners of the emerging markets universe have held up surprisingly well. Greek and Mexican stocks have even outperformed U.S. stocks in dollar terms, while other major markets like Brazil and India are trailing by only a modest margin.

This hasn’t gone unnoticed by Wall Street, where some are advising clients to consider expanding their exposure to markets once deemed too risky for many U.S. investors saving for retirement.

In a research note shared with MarketWatch, a team of equity strategists at Goldman Sachs Group
GS,
+0.69%
pointed out that emerging-market stocks excluding China had outperformed developed-market stocks excluding the U.S. so far this year.

Meanwhile, dissatisfaction with lofty valuations in the U.S., well as the prospect of another recession potentially looming around the corner have helped to embolden portfolio managers to seek out better returns elsewhere.

Times are changing

Over the past 10 years, rock-bottom interest rates helped U.S. stocks best practically all comers. During the 10 years through Monday’s close, the S&P 500 has risen 161.8% excluding dividends, while the MSCI ACWI Index
ACWI,
a broad index of developed- and emerging-market stocks, gained nearly 74%, according to Dow Jones Market Data.

Emerging markets performed pretty poorly by comparison, with the MSCI EM Index down 9.6%.

But just because EM stocks have lagged their developed-world peers for a decade doesn’t mean they are doomed to repeat this dismal performance forever. Some pointed to the torrid gains for Japanese stocks in 2023 as an example of how a market that trailed the U.S. for decades can see its prospects suddenly brighten.

Japan’s Nikkei 225
NIY00,
+1.74%
has risen more than 21% since the start of the year in U.S. dollar terms, according to FactSet.

To that end, a chorus of investment bank equity strategists along with big-name investors like GMO’s Jeremy Grantham have said a similar dynamic could play out in emerging markets.

Equity strategists like Bank of America’s Michael Hartnett and Barclays Emmanuel Cau have urged clients to look beyond the U.S. for returns. According to a research report from Cau and his team, emerging markets offer “better tactical risk-reward.” Hartnett told clients that U.S. stocks appear extremely overvalued compared with the rest of the world, and that it is time to diversify away from the U.S.

“From the perspective of relative performance, the U.S. market has been really strong the past 10 years. It wasn’t like that the prior 20 years, and at some point, a reversion will happen,” said Dina Ting, head of global index portfolio management at Franklin Templeton, during an interview with MarketWatch.

“That is helping to make the case for international markets.”

The bull case for emerging markets

With the possible exception of India, emerging-market stocks generally enjoy much lower valuations compared with their counterparts in the U.S.

That is according to a table of valuations and projected returns shared by analysts at Goldman. Many local equity markets enjoy forward price-to-earnings ratios below 10. By comparison, the S&P 500, considered the U.S. benchmark, presently enjoys a forward price-to-earnings ratio of 18.11, according to FactSet.

Developing economies have more rosy growth prospects, according to the International Monetary Fund, which released its latest batch of projections on Tuesday.

As a group, the IMF expects developing economies to grow by 4% in 2024, compared with 1.4% for a group of advanced economies that includes the U.S.

As Ting and other portfolio managers have pointed out, financials, producers of consumer goods and other industries are accounting for a growing share of emerging-market equity benchmarks. After so many years of being so heavily weighted toward China, and the commodity space, more diversity is seen as a welcome development.

Although few, if any, emerging-market economies enjoy the trifecta of rule of law, deeply liquid capital markets, and institutional independence that investors take for granted in the U.S., progress has been made. Ting cited India as a great example of a country that’s recently made major strides toward becoming more friendly toward international investors.

At the same time, paralysis in the U.S. Congress has raised concerns about potential political instability diminishing the attractiveness of the U.S. As House speakers are deposed and budget battles rage, some on Wall Street expect Moody’s Investors Service could join Fitch Ratings and S&P Global Ratings in stripping the U.S. of its AAA credit rating, as the agency has threatened to do.

Central banks in Mexico, Brazil and India have also had far less trouble tamping down inflation compared with the Federal Reserve, which also bodes well for future equity returns.

“In India and other emerging markets, certainly Brazil and others, their central banks have been much further ahead than the U.S. in fighting inflation,” said Ashish Chugh, a portfolio manager of long-only and long-short global emerging market equity strategies at Loomis, Sayles & Co.

“The U.S. government handed out free money during COVID-19, but these emerging-market countries didn’t do that. They gave out food and other stuff, but they didn’t send checks in the mail. Because of that, you didn’t have as big of an inflation problem.”

A word of caution

While emerging markets have matured in many ways, the sheer number of disparate economies and governments can make risk management difficult. The emerging-market space as defined by MSCI consists of two dozen countries.

Chinese stocks are still the most heavily represented in popular EM equity indexes like the MSCI Emerging Markets index, which is roughly 30% weighted toward the world’s second-largest economy.

Many investors in the West are already familiar with the risks of investing in China, including those emanating from China’s authoritarian system to the fallout from burgeoning geopolitical tensions with the U.S. But the potential pitfalls of investing in India or Brazil may not be quite as well understood.

That is why Zak Smerczak, an analyst and portfolio manager specializing in global equities at Comgest, would advise newcomers interested in the sector to start by investing in only the most established companies, even if their valuations don’t look quite as attractive.

“Being selective is the key,” he said during an interview with MarketWatch. “Making a broad investment in emerging markets right now seems risky to us, but there are pockets of opportunities and in specific companies.”