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How to mine the EM rubble for gems

Trader on the floor of the New York Stock Exchange.
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Trader on the floor of the New York Stock Exchange.

A golden opportunity for investing in emerging market equities may be around the corner, according to a contrarian strategist, who believes the Federal Reserve's imminent rate increase will be the ultimate opportunity for the battered asset class.

"Our view has been, you want to buy EM, and very aggressively, but you need a catalyst and that catalyst is going to be U.S. rates – the lift-off," Jason Ambrose, founder and CEO at Vanda Research told CNBC on Friday.

"Fed lift-off will be a 'sell the news' event, causing crowded trades to unwind. Two of the most crowded trades in the world are long USD and underweight ASEAN equities; both will reverse on liftoff," he said.

Emerging markets headed further south on Friday, following sharp losses on Wall Street overnight and on renewed concerns over a slowdown in China after a key gauge of the country's manufacturing sector fell to its lowest since the global financial crisis.

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Taiwan's Taiex index, Vietnam's VN index and China's Shanghai Composite index led the losses, sliding as much as 4 percent.

When the Fed hikes rates, attention will shift to U.S. macroeconomic data, which has been surprisingly strong lately, said Ambrose. This will be positive for emerging markets, he said.

"When the U.S. starts to care about U.S. macroeconomics – at the moment it only cares about oil – what do you think happens to EMs then? EMs will rip at a time of extreme bearishness," he said.

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"I don't think we're there yet, we've got a bit of time to wait, but when do get through that period, EM is going to look like the best trade I've seen in many years," he added.

Emerging markets outflows have accelerated in the recent months, with $940 billion pouring out over the past 13 months, almost double the $480 billion that flowed out during three quarters during the 2008/09 financial crisis, according to the Financial Times. The outflows have been been triggered by a host of factors including concerns around higher U.S. interest rates, slowing growth momentum and weakening currencies.

Ambrose, however, wasn't alone in his opinion that the slump in emerging market equities would soon be over.

"Jitters in the market about Fed tightening, and that China is gearing up for a currency war, suggest that momentum will drive EM equities even lower in the near term," said David Rees, senior markets economist at Capital Economics.

"But taking a step back, we see at least four reasons not to get too carried away," he said.

Firstly, current conditions in the global economy are nowhere near as bad as they were in 2009, he said. Second, the sell-off in many emerging market currencies is beginning to look overdone. Third, China is unlikely to devalue the substantially from here and spark currency warfare. Fourth, commodity price declines are likely to ease.

"Once the dust settles, we suspect they will stage a recovery and even outperform equities in the developed world in 2016-17," he said.

A targeted investment strategy

Adrian Mowat, chief Asian and emerging market equity strategist at JP Morgan, agrees price action in emerging markets reflects some overreaction on the part of investors, adding that there are plenty of opportunities to be tapped if you're willing to pick stock by stock.

"There are lots of opportunities in this narrative of 'you have to get out of everything in emerging markets,'" he said, pointing to Taiwanese tech stocks.

"Tech [stocks] has sold off dramatically – you usually see a good seasonal rebound into the final quarter," he said. "[There are] a lot of names in Taiwan with dividend yields above 5 percent and no debt on their balance sheet."

Hozefa Topiwalla, head of ASEAN research at Morgan Stanley, agrees on the importance of having a more targeted strategy for trading the current market environment.

Of all the markets in the region, he recommends betting on the Philippines. "Although it is unlikely that any ASEAN4 market will be immune to the external headwinds and growth slowdown, the Philippines is likely to be least affected by external headwinds," he said.

"Hence, despite the rising uncertainty about election outcome, we retain our relative preference for the equity market of the Philippines."