Assessing The Durability Of The Emerging Market Resurgence

With the MSCI Emerging Markets Index up 33.4 percent year-to-date, it's not surprising that some investors are wondering if they have missed the emerging markets party. Further stoking that debate is the emerging markets benchmark's 2016 gain of about 11 percent, meaning the index is approaching a two-year gain of almost 50 percent.

The good news is that fundamental factors bode well for developing world equities and the corresponding ETFs, such as the fast-growing iShares Core MSCI Emerging Markets ETF IEMG. China, the largest developing economy, looms large. China is by far IEMG's largest geographic exposure at 28.5 percent.

“The underlying fundamentals for EM equities are improving after five years of declining profitability and weak earnings growth,” said BlackRock in a recent note. “Much attention goes to China, but we see opportunities well beyond this EM powerhouse.” 

Going Beyond China

This year, some of the more volatile emerging markets have been key contributors of developing world equity market returns. For example, the iShares MSCI Brazil Capped ETF EWZ is up more than 18 percent year-to-date while the iShares India 50 ETF INDY is higher by 30 percent. Politics are helping the case for stocks in both Brazil and India, historically two of the most volatile emerging markets.

“In Brazil, labor reform passed earlier this year gives companies more flexibility in managing their workforce, potentially leading to lower labor expenses,” said BlackRock. “Elsewhere, India has seen some of the most substantial reform progress among EMs, kicked off by Prime Minister Narendra Modi’s election in 2014. Company margins in India have been challenged as the government has undertaken reforms, but they are slowly showing signs of improvement amid lower expenses and inflation.”

IEMG, which tracks the MSCI Emerging Markets Investable Market Index, allocates almost 16 percent of its combined weight to Indian and Brazilian stocks. The two countries are IEMG's fourth- and fifth-largest geographic exposures, respectively.

Central Banks Helping

While the Federal Reserve is on track to raise rates next month — marking the third such move this year — and other developed market central banks are doing the same, emerging markets central banks are going a different direction. As just two examples, Brazil and India have been voracious cutters of borrowing costs.

“We calculate seven major EM central banks, including Brazil’s and India’s, collectively delivered more than 1,000 basis points in rate cuts through October of this year,” said BlackRock. “Mexico was the only major EM central bank to increase rates in 2017. Developed markets (DMs) are heading in the other direction. The key reason for the divergence: EM disinflation.”

Indonesia and Russia, which combine for over 5 percent of IEMG's roster, are also countries that could lower interest rates.

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