Five reasons to like emerging market stocks right now

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Although the developed markets are responsible for the bulk of global economic activity, it is the emerging markets that spin the dial on global growth. Their more favourable demographic backdrop along with room for further technological convergence will ensure that this will continue in the future.

While stocks have been propelled by "animal spirits" in the aftermath of the U.S. election, the reality is that global growth (led by emerging markets) has also improved.

This has also provided a tailwind to stocks and can help explain the recent outperformance of the emerging market equities compared to their U.S. counterparts (about 650 basis points year-to-date on a U.S.-dollar basis even despite the harsh protectionist rhetoric from this new U.S. administration).

With the U.S. market the most expensive in the world, we think there are opportunities within this space.

Here are five reasons to like emerging-market stocks.

1. The U.S. dollar has stopped rising.

A massive headwind for emerging-market stocks had been the rapid appreciation of the U.S. dollar (a near 25-per-cent appreciation on a trade-weighted basis from July, 2014, to January, 2016). According to the Bank for International Settlements, U.S. dollar-denominated debt to the EMs surged to $3.3-trillion (U.S.) at the end of 2015, doubling since 2009. As the U.S. dollar rises it makes servicing this debt more expensive and weighs on domestic finances.

Indeed, emerging-market stocks substantially underperformed their U.S. counterparts alongside the weakening of their exchange rates. Now that these currencies have found their footing, this should be supportive of relative equity gains.

2. Inflation rates have eased.

Another consequence of a rising U.S. dollar had been the higher rates of domestic inflation for emerging markets.

In fact the year-over-year change in CPI is now down to 3.8 per cent in February after touching a nearby peak of 5.2 per cent in November, 2015 (this occurred in spite of a collapse in commodity prices – for context, inflation in the U.S. was running at 0.5 per cent year-over-year at this time). Lower rates of domestic inflation reduce the need for policy tightening, thereby lending support to growth while simultaneously creating the impetus for accelerating inflows to the bond market, pushing yields and the cost of capital lower.

3. Growth prospects have improved.

Emerging-market industrial production has risen to 4.2 per cent in January (on a year-over-year, three-month-moving-average basis), which is the highest such rate since November, 2014. Improved growth prospects will provide support to earnings trends.

4. Earnings are on the rise.

Alongside improved growth prospects, the analyst community is getting more bullish.

Earnings revisions are squarely to the high side, which will help to keep forward price-to-earnings multiples relatively attractive. According to Bloomberg estimates, earnings are expected to rise at a pace of about 27 per cent, year-over-year, in 2017.

5. Valuations are more compelling.

The emerging market universe commands a P/E multiple of 15.5 times (less than one standard deviation above its 10-year average) on a trailing basis and 12.7 times on a forward basis. This is considerably more favourable in comparison to valuations in the United States, which stand at 21.8 times on a trailing basis (more than two standard deviations above its 10-year average) and 18.4 times on a forward basis.

Although there is a lot to like about the recent trends in the emerging market space, risks certainly remain. Two developments we are closely watching are potential policy tightening out of China (which would have severe implications for commodities, and by extension emerging market stocks) and potential protectionist policies from this new U.S. Administration (such as a border adjustment tax or labelling China a currency manipulator). That said, we think that the potential upside is appealing even after taking these risks into account.

David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.

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