Emerging markets set to rebound

Emerging market stocks have been hammered this year, but could rebound as value investors look into an area that has become a rare bargain.

“The MSCI EM benchmark now trades on a price/ earnings [ basis] below 10 times,” Robert Buckland, global equity strategist at Citigroup Global Markets Inc., said in a note to clients. “Buying the major equity regions on this valuation has been a good strategy in the past.”

Shares in emerging market companies are down 15% year-to-date because of several headwinds, including rising current account deficits, falling commodities, a stronger U.S. dollar and GDP downgrades in countries such as China, which has been a main driver of global economic growth in recent years.

“China has fuelled global GDP expansion since the financial crisis began, accounting for 43% of real GDP growth and 23% of nominal expansion,” said Julian Callow, a Barclay’s economist. “However, Chinese economic momentum has slowed sharply already.”

Mr. Buckland said these concerns have many investors worried that emerging markets will fall further and represent a value trap at today’s levels, but he doesn’t agree.

For e xample, he said, current accounts have had a mixed relationship with equity per formance and commodity prices are falling more because of supply rather than demand issues. Meanwhile, emerging marke t GDP is still outperforming developed market growth and EM economies are now less U. S. dollar sensitive.

At the same time, the strategist believes plenty of bad news is already priced into EM stocks and that any remaining risks will not be as bad as a single-digit P/E implies.

Based on his research, there is an inverse relationship between valuations and subsequent returns at extreme price-earnings ratios below 10 times or above 20 times.

“The last three regions to trade on single-digit multiples were EM, U.K. and Europe ex-U.K. in the first half of 2012,” he noted. “All bounced strongly afterwards.”

Mr. Buckland said the current value opportunity in emerging markets is additionally attractive considering P/E multiples elsewhere. He noted U.K. stocks trade at 11.2 times, Europe ex-U.K. at 12 times, and the U.S. and Japan trade at 13 times and 13.7 times, respectively.

“The simple point is that we think the situation has to get really dire in EM to justify equities at these multiples. We do not expect that to happen,” he said.