Emerging-market stocks' latest bout of weakness likely won't last, but that doesn't mean they will outperform the U.S.

MW Emerging-market stocks' latest bout of weakness likely won't last, but that doesn't mean they will outperform the U.S.

By Joseph Adinolfi

A weaker dollar could help reverse some of a recent pullback in emerging-market stocks, but even if the Fed cuts rates, don't expect EM to surpass the U.S.

Emerging-market stocks have stumbled since hitting their strongest level in more than two years last month.

Fortunately for investors who have bought in during this year's rally, the pullback will likely prove temporary, analysts told MarketWatch. Ultimately, the Federal Reserve is expected to cut interest rates, which should help to give these stocks a boost, in part by dampening a strong U.S. dollar DXY.

"The Fed has to cut the interest rate eventually. That's the first thing that has to happen for EM to outperform," said Wongmo Kang, a senior investment analyst at Exome Asset Management, during an interview with MarketWatch.

But whether these stocks will soon see an extended bout of outperformance compared with U.S. markets looks less likely. For this to happen, there are some kinks that need to be worked out. In the mean time, U.S.-based investors may want to think twice before dedicating a sizable chunk of their portfolios to them.

Emerging-market stocks take a hit

According to FactSet data, the MSCI emerging-markets index EEM has erased more than half of what had been a nearly 9% year-to-date gain since hitting last month's two-year high.

On Tuesday, the index suffered its biggest drop since April 12, according to FactSet data. The decline was largely driven by Indian stocks INDA, which were down more than 6% in their worst day since 2020 as the party led by Prime Minister Narendra Modi saw its Congressional majority shrink following the latest election.

Elections have been a major factor driving the latest bout of weakness in emerging markets stocks. Mexican stocks suffered their worst daily drop since the COVID-19 crash on Monday, sinking alongside the country's currency, the Mexican peso $(USDMXN.FOREX)$, after Claudia Sheinbaum's Morena movement and its allies won a larger-than-expected Congressional majority.

Analysts feared the country's emboldened populist movement could seize on this to push through changes to the country's constitution.

See: Mexican peso, ETFs slammed after ruling party's election win. Here's what's worrying investors.

But most of the emerging-market index's drop over the past few weeks has been driven by a sudden pullback in shares of Chinese and Hong Kong-traded stocks last month. Hong Kong's Hang Seng index HK:HSI briefly dipped into correction territory, defined as a drop of 10% or more from a recent high, late last month, according to FactSet data.

Chinese stocks have already started to shake off these losses, having limped higher since the beginning of June. Mexican and Indian stocks may do the same, according to analysts commentary seen by MarketWatch.

Analysts at Macquarie Group argued in a report shared with MarketWatch on Tuesday that the selloff in the Mexican peso and Mexican stocks looked overdone. Investors may be overestimating the likelihood that some of the more controversial constitutional reforms proposed by the country's outgoing president would be enacted by his successor, they said.

A team of analysts at Bespoke Investment Group showed that Mexican stocks had fallen deep into oversold territory following Monday's drop. Like clockwork, the iShares MSCI Mexico ETF EWW sprang up by 2.7% on Tuesday.

Similarly, an economist at TSLombard recommended that investors should ignore the election-related concerns and consider buying the dip in Indian equities.

"In our view, investors should discount any political noise and focus on fundamentals. India's economic growth story is unlikely to change with GDP set to continue expanding at a relatively robust 6%-plus in the coming years," said Shumita Deveshwar, chief India economist at TSLombard.

See: Indian stocks crushed as ruling BJP may fall short of majority

While signs of strong economic growth in India likely bode well for Indian stocks, there are a few factors that could impede further gains, analysts say.

For one, the Indian market is expensive relative to its expected earnings. The MSCI India Index was recently trading at more than 22 times its members expected profits in 2024, even higher than the forward price-to-earnings for the U.S. S&P 500 index, according to FactSet data.

To be sure, stocks based elsewhere in the emerging markets universe enjoy much lower valuations, but just because stocks are cheap, doesn't mean they're worth buying, said Michael Rosen, chief investment officer at Angeles Investments, during an interview with MarketWatch.

Fed rate cuts should help. But profits matter more.

Although U.S. stocks are much more richly valued than their emerging-market peers, Rosen expects the U.S. market will continue to outperform - if for no other reason than its reliable history of strong profits, which have historically risen much more quickly than their international peers.

"EM markets as a whole have been less profitable. They have lower valuations, but that's because they should have lower valuations," Rosen said. Angeles has been underweight emerging-market stocks in their portfolio seemingly "forever," Rosen added.

And for years this has proven a reliable strategy, as emerging-markets have consistently underperformed the U.S. since the 2008 financial crisis.

That isn't likely to change any time soon, even as Wall Street analysts expect emerging-market companies' profits to improve in 2024. Earnings per share for firms included in the MSCI emerging-markets index are expected to grow by more than 17% this year, according to FactSet data. In 2025, the pace of growth is expected to slacken slightly to 14.6%. Still, projections for both years have large-cap emerging-market companies surpassing their U.S. rivals.

Unfortunately, emerging-market companies are notorious for underperforming analysts' expectations, said Gene Goldman, chief investment officer at Cetera Investments. He cited underwhelming results for the first quarter of 2024 as an example.

"They tend to disappoint. You'll have a crisis, or an unexpected bout of U.S. dollar strength - something always comes up," Goldman said during an interview with MarketWatch.

At the same time, U.S. stocks have a strong track record of beating Wall Street analysts' expectations. Goldman said a weakening dollar could help to justify increasing exposure to emerging-market equities, particularly in Latin America.

That could propel emerging market stocks to outperform their U.S. peers in the short term, particularly if the U.S. economy continues to cool while global growth remains robust, as recent economic data suggest.

But an extended stretch of outperformance compared with the U.S. remains unlikely.

-Joseph Adinolfi

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June 05, 2024 07:18 ET (11:18 GMT)

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