Research Affiliates: Don’t Fear Emerging Markets. Buy the Dip!

The smart beta manager says emerging markets stocks look relatively cheap and the risks of a broad funding crisis are low.

Shoppers browse a vegetable stall at a market in Dushanbe, Tajikistan. (Taylor Weidman/Bloomberg)

Shoppers browse a vegetable stall at a market in Dushanbe, Tajikistan.

(Taylor Weidman/Bloomberg)

Investors are letting fear of an emerging markets crisis get in the way of a good buying opportunity, according to investment strategy firm Research Affiliates.

They’re fleeing funds focused on developing economies even as 60 percent of the MSCI Emerging Markets Index “faces little if any risk of a funding crisis,” the firm said in a new blog posted on its website.

Emerging markets countries have become “wealthier and financially healthier” in a more stable global economy, with those under threat making up a small fraction of their combined equity value, according to Research Affiliates. The firm sees the sell-off in developing-markets stocks as overblown, providing a chance to scoop them up on the cheap.

“When the risks and the bad news are well known to the market and fear reigns supreme, it’s time to buy, not sell,” wrote Research Affiliates’ chief investment officer Chris Brightman, macro research head Michele Mazzoleni, and product management head Jonathan Treussard.

Emerging countries have a low risk of a broad funding crisis based on their external debt to gross domestic product ratio, foreign exchange reserves, and current account balances, according to the authors. Plus, their stock markets are trading at cheap levels.

Even after emerging markets stocks delivered a nearly 100 percent total return from early 2016 lows, they remain comparatively cheap when looking at such measures as cyclically adjusted price-to-earnings, market value-to-GDP, and price-to-book ratios, the authors said.

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But stocks tied to developing countries have seen a steep drop this year. They tumbled 11 percentage points from their peak this year on January 25 through June 15, according to Research Affiliates, sparking investor concern about a broadening crisis.

“We feel the fear,” the authors said. But deciding whether to abandon equity positions in emerging markets requires analyzing the risk of a broad funding crisis with “our frontal cortex rather than with our limbic system.”

While a 10 percent correction in the U.S. market is typically seen as an opportunity to “buy the dip,” investors’ instinctive reaction to a similar decline in emerging markets is “contagious fear,” the Research Affiliates authors said in their blog.

Yet, by their estimates, less than 20 percent of the MSCI Emerging Markets Index seems at elevated risk of a funding crisis.

“With only a few small markets at any material risk of crisis, EM equity markets seems to provide fair compensation for their risks,” Brightman and his colleagues concluded.