November 8, 2012

Once the darling of the investment universe, emerging market stocks have performed poorly against their developed counterparts for the past two years. But Todd Henry, a portfolio specialist who works with T. Rowe Price's emerging markets equity managers, explains why the underlying growth story in the developing world remains solid and why now may be a good time for some investors to build exposure to emerging market stocks.

Emerging market stocks have underperformed developed market stocks since the start of 2011.
  • Global macroeconomic concerns (European debt crisis, China's slowdown, the U.S. fiscal cliff) have caused investors to sell out of emerging market equities and riskier assets.
  • Emerging market stocks are perceived as riskier assets and, therefore, have lagged as investors have sought to reduce risk.
  • Currency weakness also has contributed to weak performance.
  • The BRICs—Brazil, Russia, India, and China—have been poor performers.
We believe China will successfully manage a "soft" economic landing.
  • China's gross domestic product (GDP) growth has slowed from 10% to 7%. This deceleration is something we've expected and something China's government has been trying to achieve.
  • China does not need its economy to grow 10% per year or create the same number of jobs it has in the past. Over the medium term, we foresee annual GDP growth of 7%—still very good growth relative to many other countries.
  • China is transitioning from a manufacturing and export-driven economy to one led by domestic consumption. The outlook for consumer-driven businesses remains favorable.
Across the developing world, consumers are growing richer—opening up attractive opportunities.
  • In emerging markets, wages have been increasing at a double-digit pace. Unemployment is very low, savings rates are high, and personal indebtedness is low. Individual balance sheets are very strong.
  • The consumer culture in many developing markets has plenty of room for growth. Levels of penetration for food retailing and the Internet are very low. However, stock prices for many consumer-driven investments in emerging markets have become expensive, so it's important to be selective.
Overall, emerging market stocks are currently trading at attractive levels, creating a potentially good entry point for long-term investors.
  • We think valuations generally are attractive. Emerging market stocks are currently trading at 10 times forward price to earnings. Over the past 20 years, there probably have been four or five times where investors could buy emerging market stocks at those levels.
  • Near-term risks could lead to more weakness in the short term. But we believe now is a good time to build exposure to emerging markets, particularly for investors with a medium- to longer-term time horizon.
  • Despite slowing growth, fundamentals remain strong in most emerging markets. Most have favorable fiscal positions, have healthier consumers, and enjoy a higher level of overall growth compared with developed countries.
Nevertheless, global macroeconomic events continue to present near-term risks for emerging market stocks.
  • Investors are still worried about Europe. The eurozone economies are still slowing, and it will take years to work out their significant debt levels.
  • We anticipate China will experience a soft economic landing. But if we're wrong, that will be a negative.
  • We have only a few months to address the U.S. fiscal cliff, which has worried investors and kept them away from investing in equities, particularly in emerging markets.

There are inherent risks associated with investing in the stock market, including possible loss of principal, and investors must be willing to accept them. International investing is subject to unique risks including unfavorable currency exchange rates and political or economic uncertainty abroad. Investments in emerging markets are subject to the risk of abrupt and severe price declines.

The views are as of October 26, 2012 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.