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Some Believe Emerging Markets Are Beckoning

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Some Believe Emerging Markets Are Beckoning
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Emerging markets equity have spent most of 2018 slumping and with just a few trading days left in the year, those pains are getting worse.

Following commentary from the Federal Reserve that was more hawkish than expected, the MSCI Emerging Markets Index fell 1.66 percent, extending its fourth-quarter decline to 9.56 percent. Down more than 18 percent year-to-date, the widely followed gauge of developing world stocks resides just 2.44 percent above its 52-week low.

What Happened

As has been the case during previous down years for emerging markets stocks and exchange traded funds, the asset class doesn't lack for supporters. Just look at the iShares Core MSCI Emerging Markets ETF (NYSE: IEMG).

That fund, one of the least expensive emerging markets ETFs, is down nearly 17 percent this year, but investors are flocking to it. IEMG has seen year-to-date inflows of $14.85 billion, a total surpassed by just three other U.S.-listed ETFs.

Why It's Important

A frequent rallying cry for emerging markets stocks is that they're inexpensive on valuation, a familiar refrain from prior bear markets.

“Emerging market stocks were inexpensive in July; they are cheaper today,” said BlackRock in a recent note. “Based on trailing earnings, the price-to-earnings (P/E) ratio has dropped from 13.1 to 12, the cheapest since late 2015. On a relative basis, the MSCI Emerging Market Index is still trading at a 30% discount to developed markets, close to the bottom of this cycle’s range.”

IEMG, which holds over 1,800 stocks, has price-to-earnings ratio of just over 12 times, implying discounts to developed markets benchmarks. A valuation issue for IEMG is just how inexpensive investors see China as and if that's enough to embrace stocks in the world's second-largest economy. China is 28.67 percent of IEMG's geographic exposure, more than double the fund's second-largest country weight, which is South Korea.

What Happened

If the Fed obliges and slows its pace of rate hikes next year, that could ease the pain of dollar strength, a critical factor for IEMG's fortunes.

“After rallying 10% from the February low to the August high, the rally has started to stall. While the Dollar Index (DXY) did make a nominal high in mid-November, more recently the index has been stuck around 96-97,” said BlackRock. “This is important. In the post crisis-world a rising dollar has been associated with weaker EM returns. Since 2010, monthly changes in the dollar have explained roughly 30% of the variation in emerging market equity returns. A flat dollar removes a key headwind.”

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