To The Moon

How to Play the Rebound In Emerging Markets

For investors in emerging markets, September brought a welcome double dose of good news.

Days after the Federal Reserve cut interest rates to keep the U.S. economy humming, Chinese policymakers ratcheted up their efforts to stabilize their struggling economy.

Emerging markets tend to do well when the Fed is cutting rates and the dollar is weaker, in part because it lowers interest-rate costs for companies and entices U.S. investors to get more for their dollars abroad.

The other big boost: China. After a continued deterioration in the economy, Beijing last month took coordinated steps to stabilize the situation -- bigger interest rate cuts, proposals to support the domestic stock market, and vows for more fiscal stimulus. That sent Chinese stocks soaring, making them the best asset class in the past month with a 30% gain.

It has been a long wait. Emerging markets have been in the shadows of U.S. stocks for the past decade. The $S&P 500(.SPX)$   trounced everything else, returning a cumulative 250% compared with 53% for the MSCI Emerging Markets index. But in August and September, emerging markets started to outperform, returning 8.4%, beating the S&P 500 by four percentage points.

That doesn't guarantee smooth sailing. Details on both size and scope of China's stimulus are still a mystery. Volatility is likely to continue in coming months as investors dissect the specifics and analyze its effectiveness.

But even fund managers who are skeptical that Beijing's measures will heal battered household and business confidence see the new stance from policymakers as a marked change that should help the market in the near term.

Good news related to China helps emerging markets -- and not only because China makes up the largest weighting in the index at almost 30%. Emerging markets broadly are well positioned for the geopolitical shifts at play.

As the U.S.-China rivalry reshapes global trade, Jorry Nøddekaer, head of the Polar Capital Emerging Markets & Asia Team, sees a shift toward a multipolar world where capital and growth shift away from China and toward countries like India, Vietnam, Indonesia, and Mexico. Those countries become critical to companies -- and other nations -- as they try to diversify away from China or become more self-reliant.

As China's economy and market struggled in recent years, India emerged as a star, with the MSCI India index returning 51% while the MSCI China index lost 15% over the past three years. The draw for India: an economy growing at 7%, a young population, and a slew of reforms that have made it more hospitable to foreign investment, as well as improved digital and physical infrastructure and a bolstered manufacturing sector.

The trouble is that the India market is expensive at almost 24 times next 12 months' earnings, near a record high. With a red-hot public offering market and money flooding in, longtime investors are turning cautious.

"We are setting up for a major correction in India in the next year. People are so euphoric," says longtime India investor Ajay Krishnan, lead manager of Wasatch Emerging Markets Select fund (WAESX), which has beaten 94% of its peers over the past five years by averaging a return of 10%.

Catalysts for such a pullback range from a weaker showing for Prime Minister Narendra Modi's coalition in state elections in coming months or more enthusiasm for China that leads investors to reshuffle allocations.

But Krishnan welcomes any correction, as it would give him the chance to buy in a market that he sees as a winner over the long haul. For now, he favors higher quality stocks with strong fundamentals that the market has been ignoring.

Other parts of emerging markets are also drawing interest, though they account for a tiny part of the index. The prospect of a broader war in the Middle East is a risk, but investors are still flocking to the United Arab Emirates and Saudi Arabia. In the U.A.E., more than a dozen companies are ready to go public, with another handful in Saudi Arabia.

"There's broad-based growth, with the U.A.E. emerging as a spot for cutting-edge technology and focus on artificial intelligence and smart meters," says Rajiv Jain, chief investment officer and manager of GQG Partners Emerging Markets Equity fund (GQGPX), which has averaged a return of 10% a year for the past five years, beating 93% of its peers.

Countries in southeast Asia, including Indonesia and Vietnam, are also well positioned for the continued shifting of global supply chains and push by countries to become more self-reliant. They also stand to benefit from improving economic conditions in neighboring China.

Earnings have been strong in Indonesia, and Jain favors banks like PT Bank Mandiri as a broad way to play that nation. Indonesia has emerged as the world's biggest supplier of nickel and is moving to encourage increased investment into the country for those who want to tap its resources.

The battle between the U.S. and China for critical minerals could benefit Indonesia and Chile, with their reserves of copper, higher investment, and exports, according to a recent note from William Jackson, chief emerging markets economist for Capital Economics.

South Korea and Taiwan stand to benefit amid strong demand for semiconductor chips and other advanced manufacturing. Valuations in some of these companies are also becoming more attractive, according to Nøddekaer.

But China is likely to remain in the spotlight. The surge over the past couple of weeks has been swift. Skittish investors had pared back China allocations, worried about the economy's trajectory, policy missteps by Beijing, and the risks related to rising geopolitical tensions with the U.S.

The sudden move higher sparked a fear-of-missing-out-type rally: One of the cheapest markets -- trading at nine times forward earnings just a few weeks ago -- is now trading closer to its long-term average at 11.7 times.

HSBC strategists still see up to about 20% gains in China's stock indexes such as the CSI 300 as Beijing rolls out details of its policies. That didn't come on Tuesday when the National Development and Reform Commission disappointed the market with no specifics, though Jing Liu, HSBC's greater China chief economist, noted that such specifics would come from the Ministry of Finance and urged clients to have some patience.

Even then, some are skeptical the measures will heal the structural issues the country faces. For Varun Laijawalla, co-manager of Ninety One's emerging markets equity strategy, the scale of China's property bust is a lingering concern. He estimates that more than 90 million units are sitting empty -- almost a decade's worth of inventory.

For now, Laijawalla and other longer-term investors are looking for pullbacks to add stocks that are likely to benefit from stimulus directed at lower-income consumers, including consumer staples such as beverage firms or appliance makers. Another strategy is to grab companies already seeing stronger earnings trends on their own.

Wasatch's Krishnan, who is skeptical about the staying power of the rally, is sticking with companies like $Trip.com Group Limited(TCOM)$   Group and Meituan as Chinese consumers continue to splurge on experiences, particularly travel.

The Vanguard Emerging Markets Stock Index fund (VEMAX) is one of the cheaper broad-based ways to tap the asset class, charging an expense rate of 0.14%. The fund's top holdings include stocks that active managers are leaning toward, irrespective of China's economic prospects. Among them: $Taiwan Semiconductor Manufacturing(TSM)$  , $TENCENT(00700)$  , and $MEITUAN-W(03690)$ .

As of the end of August, the fund had a quarter of its allocation in China, another quarter in India, 21% in Taiwan, and almost 8% in the Middle East, in line with the index.

Among active funds, Jain's GQG and Krishnan's Wasatch Select both have strong longer-term records. The value-oriented $T. Rowe Price (TROW.US)$ Emerging Markets Discovery fund (PRIJX) has less exposure to both China and India than peers, and a heftier helping to Korea, Thailand, and Indonesia. Top holdings include Saudi $National Bank (NBHC.US)$ and $PT Bank Rakyat Indonesia (Persero) Tbk Unsponsored ADR Class B (BKRKY.US)$. The fund's 30% return over the past year beats 70% of peers, according to Morningstar.

For those wary of China and India, given the run-ups in these markets, the Freedom 100 Emerging Markets exchange-traded fund (FRDM) avoids both, as the fund steers clear of countries with autocracy risk, favoring those that rank higher on its Freedom score based on personal and economic freedoms.

The fund has 17% of its assets in Chile, with holdings like miner $Sociedad Quimica Y Minera De Chile (SQM.US)$, which is well positioned for increased demand for lithium and nickel; 3% in Indonesia; and big stakes in Taiwan, with 28% of assets, and Korea, with 15%.

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