Risk aversion means emerging stocks have underperformed this year given relatively sound fundamentals, but that may be about to change as investors appreciate their low valuations.
Emerging stock valuations have fallen to historically low levels as the benchmark MSCI emerging markets index has dropped more than 6 percent this year, broadly in line with global stocks.
Strong fundamentals and a return of risk appetite helped emerging markets outstrip major bourses last year, rebounding 75 percent against a 32 percent rise in global stocks.
This year, they have generally failed to capitalize on sounder economic fundamentals as risk aversion has returned, but attractive valuations put them in line for a recovery in the second half, analysts and investors say.
Allan Conway, head of emerging equities at fund manager Schroders, says emerging stocks could rise 20 percent to 30 percent on a six-month to 12-month view.
"One of the surprising things is that emerging equities have come off as much as they have — the underlying fundamentals are much better than developed (markets)," said Conway.
"We are not looking at the same sort of problems that the developed world is facing; of high levels of debt, the need for massive fiscal constraint, very weak growth. We have much stronger decoupling of fundamentals than of the stock markets."
Morgan Stanley last month shifted to an increased overweight position in emerging equities, its first position shift on emerging assets in nearly a year, saying the index's valuations were one standard deviation below their long-term average.
Emerging equities' 12-month forward price-to-earnings ratio of 9.6 times and trailing price-to-book of 1.76 times have reached trough levels from the 2004 cycle, the bank said in a client note.
Their forward PE ratio was above 13 before the global stock sell-off earlier this year.
Cheaper valuations in markets such as Russia and China have started to attract investors once more following a May sell-off, according to data from EPFR Global, which monitors fund flows.
Fears of policy tightening and moves to curb property prices have weighed on China and Hong Kong shares. Shanghai has been one of the world's worst-performing bourses this year, sliding more than 20 percent, but markets have picked up since news last week that China's exports surged nearly 50 percent in May.
"China is historically toward the bottom, Russia is one of the cheapest markets in the world, provided oil stays reasonably firm," said Conway. Schroders is already overweight on Russia and is "getting very close to overweight" on China and Brazil, he said.
Brazil's economy roared ahead at its fastest pace in at least 14 years in the first quarter while the International Monetary Fund on Tuesday raised its 2010 growth forecast for Russia to 4.25 percent, from 4 percent, citing increased consumption.
While economic fundamentals are improving, a spate of IPOs in the pipeline, some of which were delayed due to weak market sentiment, could weigh on demand for emerging assets.
Agricultural Bank of China has reduced the size of its IPO plans from $30 billion, which would be the world's largest IPO, to around $23 billion, and several Russian companies have delayed IPOs.
Even with delays, emerging market IPOs this year are already at full-year 2008 levels and have clocked up more than half full-year 2009 levels, a possible warning to investors.
"When IPOs are abundant, the market is peaking," said Kees Verbaas, executive director, emerging markets at fund manager Hermes. "We saw that in 2008 also."
Eastern Europe, meanwhile, is seen as more risky than other emerging markets as sentiment is being affected by worries affecting peripheral euro zone countries.
Comments by Hungarian officials, later downplayed, suggesting the country might be facing a Greece-style debt crisis sent markets into a tailspin this month. Hungary has debt at around 80 percent of GDP, the highest in emerging Europe but well below Greece's debt at 120 percent.
"Central Europe is a really small part of the MSCI emerging benchmark," said Mihail Dobrinov, fund manager at Principal Global Investors in Des Moines, Iowa.
"It's surprising how much Hungary affected global markets for a day or two but this is what happens when volatility and risk premiums are high — correlations go up."
Most of the bigger emerging markets have low levels of debt: China has a debt-to-GDP ratio of less than 20 percent, while Russia's is under 7 percent.
Jeff Chowdhry, head of emerging equities at F&C, said the emerging markets' index could rise by around 15 percent from current levels by the end of this year.
"We are definitely at the attractive end, I would be putting some money to work," he said.
"I would not be jumping up and down and putting everything in."
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