Emerging markets may soon be safer

But some of these economies need to first arrest the decline in their currencies, experts say

Just as the Federal Reserve steadily picks up the pace of rate increases, Wall Street’s quantitative strategists are telling clients to sell US stocks and buy into emerging markets.

US central bankers are increasingly confident in their view of the economy. Of the Fed’s 16 voting members, 12 are advocating for one last rate increment this year, bringing the 2018 total to four.

So, given the 2013 taper tantrum and the 1997 Asian financial crisis, it’s a bit surprising that Wall Street is turning bullish on emerging markets now. The key is valuations.

According to Credit Suisse’s HOLT, an accounting framework that sifts through more than 20,000 companies in 65 countries, the premium of developed markets over their emerging counterparts is at a historical peak. This year, the S&P 500 Index has outperformed the benchmark MSCI Emerging Markets Index by almost 18 percentage points.

Many on Wall Street worry that the American market is too expensive. Since 1981, the S&P 500’s cyclically adjusted price-to-earnings (or Cape) ratio has been higher only once, and that was at the peak of the dotcom bubble.

Valuations aside, many just don’t believe the US can remain immune from the fallout of a global trade war while the rest of the world suffers. Sooner or later, American shoppers will feel the pinch: almost one-quarter of the $200 billion (Dh735 billion) Chinese products subject to higher tariffs are consumer goods.

Beyond the immediate outlook, even Fed board members are divided on what the economy will look like in 2020. Of the voters, nine see at least one rate increase then. Three reckon the central bank will have to revert to easing that year.

So if you believe the decoupling of US and emerging markets can’t last, “the time for the rotation may be now,” JPMorgan strategists said in a note. Stock markets tend to anticipate economic performance by six to 12 months.

Currency factor

EM stocks can’t rally unless their nations’ currencies stabilise first. In emerging Asia, at least, the grown-ups seem to be in charge. Indonesia, suffering from a widening current account deficit, and the Philippines, beset by inflation, have both boosted interest rates by 1.5 percentage points this year.

You could even say a minitaper tantrum has already happened. Hedge funds have been selling steadily out of MSCI Emerging Markets futures this year.

There are two ways for these markets to get back in the same orbit: either through an EM rally or an American correction. Either way, emerging markets look like the safer place to be.