While Emerging-market Stocks' Latest Bout of Weakness is Likely to Pass, It Doesn't Mean They Will Outperform the U.S.

Emerging-market stocks have recently stumbled after reaching their highest levels in over two years last month. However, analysts suggest that this setback is likely to be temporary. A future interest rate cut by the Federal Reserve is expected to provide a boost to these stocks by weakening the strong U.S. dollar.

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“The Fed has to cut the interest rate eventually. That’s the first thing that has to happen for EM to outperform,” said Wongmo Kang, a senior investment analyst at Exome Asset Management, in an interview with MarketWatch.

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Nevertheless, it's uncertain whether emerging-market stocks will soon outperform U.S. markets for an extended period. There are several issues that need to be resolved first. In the meantime, U.S.-based investors may want to reconsider allocating significant portions of their portfolios to these stocks.

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The MSCI emerging-markets index (EEM) has lost more than half of its nearly 9% year-to-date gain since reaching a two-year high last month, according to FactSet data. On a recent Tuesday, the index saw its biggest drop since April 12, driven primarily by a more than 6% decline in Indian stocks (INDA) after Prime Minister Narendra Modi's party lost its Congressional majority in the latest election.

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Elections have played a significant role in the recent weakness of emerging-market stocks. For instance, Mexican stocks experienced their worst daily drop since the COVID-19 crash, falling alongside the Mexican peso after Claudia Sheinbaum’s Morena movement and its allies gained a larger-than-expected Congressional majority. Analysts are concerned that this could lead to significant constitutional changes by the populist movement.

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The recent pullback in emerging-market stocks has been mostly driven by a sudden decline in Chinese and Hong Kong-traded stocks last month. Hong Kong’s Hang Seng index briefly entered correction territory, defined as a drop of 10% or more from a recent high. Despite this, Chinese stocks have started to recover since early June, and analysts expect Mexican and Indian stocks to follow suit.

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A report from Macquarie Group suggested that the selloff in the Mexican peso and stocks was overdone, with investors potentially overestimating the likelihood of controversial constitutional reforms. Bespoke Investment Group noted that Mexican stocks had fallen into oversold territory, leading to a rebound of 2.7% in the iShares MSCI Mexico ETF.

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Similarly, TSLombard economist Shumita Deveshwar advised investors to ignore election-related concerns and focus on fundamentals, highlighting India’s robust economic growth forecast of over 6% in the coming years. Despite this positive outlook, the Indian market is expensive relative to its expected earnings, with the MSCI India Index trading at more than 22 times its expected profits for 2024, higher than the forward price-to-earnings ratio for the U.S. S&P 500.

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Emerging-market stocks generally have lower valuations compared to U.S. stocks, but this does not necessarily make them better investments, according to Michael Rosen, chief investment officer at Angeles Investments. He noted that U.S. stocks have historically outperformed due to their strong profitability, a trend expected to continue.

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Rosen pointed out that emerging-market companies have a history of underperforming analyst expectations. This pattern has persisted since the 2008 financial crisis, with emerging markets consistently underperforming compared to U.S. stocks. Analysts project that earnings per share for companies in the MSCI emerging-markets index will grow by over 17% in 2024, with a slight slowdown to 14.6% in 2025. Despite these optimistic projections, emerging-market companies often fall short.

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Gene Goldman, chief investment officer at Cetera Investments, mentioned that emerging-market companies often face unexpected challenges, such as a stronger U.S. dollar, which can negatively impact performance. Although a weakening dollar could justify increased exposure to emerging-market equities, especially in Latin America, sustained outperformance compared to U.S. stocks remains unlikely. Recent economic data suggest that while the U.S. economy may cool and global growth remains robust, a prolonged period of emerging-market outperformance is not expected.

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