Is the bloom off the rose of emerging markets?

Gone are the days when investing in emerging markets was considered to be taking great risk. As emerging economies continue to grow and stabilize, so too does their presence in common investment discourse and portfolios. As such, it appears timely to revisit the dynamics that drive these markets and ask ourselves: How attractive are emerging markets for investment now?

Starting from the highest level, growth (as defined by gross domestic product) has been slowing in emerging markets. The gap between emerging and developed markets now is narrower than at any time since the Asian financial crisis. The booming growth seen between 2000 and 2008 is unlikely to return.

How should investors interpret this transformation? Emerging markets growth still is forecast to remain twice the level seen in the developed markets. And while this differential is narrower, high multiples of growth in the developed markets is not a prerequisite for attractive returns over the next several years.

Prior to the global financial crisis, the growth model of the China-led emerging markets was straightforward: export the finished product to developed markets and capitalize on the trade income (current account surplus). If the country was not an exporter of finished goods, it surely was a part of the supply chain, all the way down to natural resource extraction.

Today we find ourselves in a much different environment. Developed economies are importing less and saving more, resulting in surplus levels of raw materials, overcapacity of manufacturing and excess inventory.

The development of a service-driven economic model depends on structural reforms that increase productivity, enhance the purchasing power of households and enable further development of the services sector. Sensing a regime change instead of a temporary disruption, many emerging economies have started the painful transition to domestic demand growth drivers. This is a slow-moving, politically fraught process.

However, this is not all bad news for the patient investor. While some emerging economies should be approached with caution, others represent opportunities for investment — untangling the two is key.

It's no secret that earnings in emerging markets have come under pressure from the aforementioned factors. Many commodity-exporting economies — such as Russia, Indonesia and Mexico — have posted double-digit earnings declines, causing many investors to rethink their dedication to the poster child of “high-risk, high-reward” investing.

It is important to keep in mind that currencies play a significant role for U.S.-based investors. Following are two examples of how headline figures can be misleading. First, in the earnings world: The earnings per share decline in Russia toward the end of 2015 was nearing 70% in U.S. dollar terms, a number that gave many investors vertio. Recalculating for local terms, however, reveals the decline is only about 35%, more palatable given the move in commodities.

Perhaps the best example of how large currency swings can convolute the picture of corporate performance is seen in equity indexes. The MICEX (Russia's primary equity index) returned just 0.4% to U.S. dollar investors after dividends in a year where the S&P 500 returned 1.4%. However, from the perspective of a ruble investor, the MICEX returned 32% — not a bad year.

Is there reason to believe more emerging market currency weakness is on the way given the Fed has initiated its hiking cycle? Unlikely. The path of rates is accounted for in the pricing of currencies. Furthermore, the hiking cycle at hand will end at a lower level of interest rates and arrive at that level with a much slower pace.

As external demand for emerging market goods wanes, supportive monetary policy has aimed to fill that void. Making borrowing easy, known as credit expansion, has been a popular tool of choice for central bankers. Like many constructs of society, credit expansion also is subject to the law of diminishing returns, and some economies seem keen to find where the asymptote ends.

China, for instance, could generate one yuan of additional GDP with a little over one yuan of credit prior to the global financial crisis. Now, it takes about four yuan to generate that same amount of GDP growth. Does that mean China is going to experience a hard landing and send shocks throughout the global economy? The central planners of the Chinese economy have a strong grip on the economic levers and likely will do anything that they can to prevent a hard landing. Will there be intermittent pain? Surely.

Starting with the growth trend of emerging markets and working down to the nuances of borrowing at the country level highlights how investors should think about investing in emerging markets: One country is not the same as the next.

This seems like a very simple concept, but unfortunately is not how investing in emerging markets is typically approached. To increase their chances at higher risk-adjusted returns, investors must realize that the emerging markets are not a monolith.

In analyzing a country, we prefer to start with a cyclically adjusted price-to-earnings ratio and how the current level relates to itself historically. Next, we consider whether investing in that country provides “growth at a reasonable price” by analyzing what we have come to call the CAPE(G) — the cyclically adjusted price-to-earnings ratio divided by the country's growth rate.

Looking “under the hood,” however, highlights how treating emerging markets as a monolith can be a dangerous simplification. Some countries offer similar historical valuations relative to the S&P 500, as well as similar growth-adjusted valuations (e.g. Indonesia, Philippines). Others have higher historical valuations and worse growth-adjusted valuations to the S&P 500 (South Africa). Finally, there are countries that have moderately attractive historical valuations but similar-to-worse growth-adjusted valuations than the S&P 500 (China, Malaysia).

None of the aforementioned are priced to reward the investor for taking emerging markets risk. What remains are countries that offer similar or better historical valuations with attractive growth-adjusted valuations (Chile, Turkey, Russia, and India).

Diversifying investments serve an important purpose in any portfolio construction process. Therefore, it is critical to ask whether emerging market exposure is diversifying. In the context of emerging markets, this boils down to whether an index actually provides access to an EM-specific risk factor, or whether that index is just a global equity risk factor disguised in EM clothes. For instance, commodity-exporting countries in general exhibit high betas to developed markets, as does the MSCI EM index as a whole, given that both have significant global export-led company exposure. By contrast, the more “frontier” markets offer the lowest betas and therefore the greatest diversification benefits due to their lower level of integration with the global economy.

When considering emerging market investment, investors today must not be trapped by generalization and remain cognizant of the macroeconomic drivers and market conditions in each individual country. While there may be a trend toward index products for capturing S&P 500 risk and the like, the law of unintended consequences is surely at play in emerging market index products, underscoring the need for careful investment.

Michel Del Buono is managing director and global strategist at Makena Capital Management, Menlo Park, Calif.