An Emerging Opportunity in Stocks

JULY 1, 2011    THE WALL STREET JOURNAL

By RICHARD BARLEY

Emerging-market equity investors had a tough time in the first half of 2011. But will the second half offer richer pickings?

The MSCI Emerging Markets index is down 0.4% so far this year, underperforming the developed-market MSCI World index which is up 4.0%. Middle Eastern stocks have been hit by regional political turmoil, Eastern Europe has been affected by the euro-zone crisis, and Latin American and Asian stocks have suffered as inflation and growth fears combined. In contrast, developed market equities initially rallied on hopes for U.S. growth and have suffered less even amid rising risk aversion.

But that is creating opportunities: all four of the BRIC markets are trading cheap to their five-year average valuations, according to HSBC Global Asset Management: China, for example, trades at 10.7 times 2011 earnings versus a five-year average of 13.5 while Russia trades at 5.9 times 2011 earnings versus a long-term average of 8.2.

Much of the case for emerging market equities remains intact. Growth is still expected to be strong: the IMF looks for emerging-market growth to average 6.6% over the next five years versus 2.5% for advanced economies, while inflation should decline.

Emerging economies are close to balanced budgets and debt-to-GDP should decline. Rising consumer wealth and deepening financial markets should support asset prices. U.S. monetary policy is set to stay loose, providing liquidity support.

Meanwhile, some concerns holding back valuations are now receding. In India and China, for example, central banks may now be close to the end of rate-hike cycles even if some smaller economies, such as Indonesia, Turkey and South Africa, are lagging. And while stocks have fared poorly, emerging fixed-income and currencies have done well, suggesting investors have simply been changing the way they take exposure.

Risk appetite remains key: emerging markets still can't decouple from global markets. Renewed euro-zone tensions or continued growth fears could lead to safe-haven flows into the U.S. dollar, denting returns. But if the soft patch proves to be just that, then emerging market stocks could shine later this year.

Write to Richard Barley at richard.barley@dowjones.com