Emerging markets have been garnering renewed interest lately.
The iShares MSCI EM index EEM, +0.05% which tracks 23 emerging markets, jumped 3.9% last week to a 20-month high after the Federal Reserve raised interest rates as anticipated and indicated two more hikes this year. The S&P 500 SPX, -1.24% edged up 0.2% for the week while the iShares MSCI World ETF URTH, -1.06% gained 0.9% last week.
The rally in emerging markets coincided with a move by J.P. Morgan strategist to upgrade the group from neutral to overweight on accelerating earnings and the narrowing gap in growth between EM and developed economies.
Mislav Matejka, an equity strategist at J.P. Morgan Cazenove, on Monday reiterated his buy recommendation, noting that emerging markets tend to perform well when the Fed tightens monetary policy.
“MSCI Emerging Market outperformed Develop Market during three of the last four hiking cycles,” said Matejka in a report.
That may fly in the face of convention because a stronger dollar, typical of rate hikes, tends to make dollar-denominated debts more difficult for emerging-market countries to service.
However, expectations that the U.S. dollar DXY, -0.65% trading near its 14-year high, will weaken in the second half of the year support EM stocks given their negative correlation to the greenback, he said.
Furthermore, EM valuations remain attractive versus developed markets, trading at a 30% discount, according to the strategist.
“EM are far from over-owned, even though they had net inflows over the past three quarters. They are still sitting on 50% relative underperformance since 2011,” Matejka said.
Among emerging markets, J.P. Morgan favors China and Brazil.
Bank of America Merrill Lynch also maintained its positive view on EM stocks as central banks in developing countries are synchronizing their policies with the Fed, with 10 out of 15 emerging markets signaling the possibility of higher rates over the coming year. The People’s Bank of China raised its short-term rates following the Fed’s hike of a quarter of a percentage point to a range of 0.75% to 1%.
Still, betting on emerging markets isn’t without risks, strategists warned.
The Chinese government’s plan to balance growth and financial stability could easily unravel while investors are likely underestimating the potential for trade friction with the U.S., said David Cui, Bank of America’s China equity strategist.
Bank of America recommended Russia and Brazil over other emerging markets, noting that Russia continues on its recovery path while Brazil is pushing ahead with reforms as the country’s central bank has kept interest rates low to pull the economy out of recession.
On Wednesday, Moody’s revised its outlook on Brazil’s Ba2 credit rating to stable from negative to stable as the country’s economy is showing signs of recovering as inflation eases.