Is it a good time to buy into beat-up emerging markets stocks and bonds?
Assets in the high-risk, high-return sector are arguably cheap after the last few dismal years. Prices briefly rose after the swoon that followed the devaluation of the Chinese yuan in August, but they have fallen further with the recent volatility in China and are well below their post-financial crisis highs.
"Emerging markets stocks are cheaper than they have been historically, relative to themselves and to the rest of the world," said Gary Ribe, chief investment officer for financial advisory firm Macro Consulting Group. "The question is whether the valuation gap is big enough now to invest more in the sector."
Ribe thinks not. He says his firm is considering increasing its allocation to emerging markets to a market weight position based on the low valuations (emerging markets represent about 10 percent of global market capitalization), but he's not yet ready to make the change.
"We won't eliminate our exposure, but we don't see a strong case for earnings unless commodity prices recover," Ribe said. "For now, we're standing pat."
The big uncertainty with emerging markets is the slower growth profile of China. The law of large numbers has finally caught up with the world's second-largest market as it tries to engineer a soft landing for its decelerating economy.
The ongoing shift from a debt-fueled corporate investment and government infrastructure-led economy to one driven by its own consumers will result in permanently slower growth going forward. Before the financial crisis, China's economy was regularly expanding at a double-digit annual growth rate. It's now growing at a 6 percent to 6.5 percent clip, say most analysts. Emerging markets as a whole have slowed from 7 percent to between 4 percent and 5 percent.
"It's not a cyclical slowdown," said Roger Aliaga-Diaz, a senior economist at Vanguard Group. "This is a permanent secular adjustment. China and the emerging markets will have lower but more sustainable growth now."
Just how much lower is the still unanswered question. For the last decade, China has been the biggest marginal consumer of the commodities and raw materials that fuel many of the economies of other emerging markets. The modest slowdown of Chinese demand has pulled the rug out from under a wide range of commodity markets.
While economists don't see a lot of risk of further declines in already moribund prices, they also don't see many factors that suggest a speedy recovery.
According to Gabriel Sterne, an economist with Oxford Economics, "2015 will be the worst for [emerging markets] GDP growth since 2001." He added, "Trade channels and commodity channels are very correlated in emerging markets. It's been a disaster for global trade."
The bearish case on emerging markets is that high debt levels across many countries could make the slower growth scenario even harder to deal with. Private debt in the emerging markets has tripled from $11 trillion to $33 trillion over the last seven years.
While less of the corporate debt raised these days is now dollar-based, some countries, such as Turkey and Chile, still have very high levels of foreign currency–denominated debt and will be vulnerable to further rises in the U.S. dollar.
"There have been big increases in private debt all over emerging markets," Sterne said. "It's a big worry in one sense, but in another it's good that it's happening in a low-rate environment."
Another concern is currencies. Most emerging markets countries have abandoned fixed exchange rates on their currencies, and they generally have high levels of foreign reserves to use as a buffer against shocks.
The Chinese stock market plunged after the central bank devalued the yuan in August, and further worries about the currency and China's slowing economy have contributed to a very volatile start to the new year.
The other big question is how rising interest rates in the U.S. will affect currencies and capital flows in emerging markets. The Federal Reserve's first rate hike in December may not have caused the turmoil in markets, but it didn't help. While another rate hike in March is now likely off the table, rising rates in the U.S. will pressure other currencies and emerging market financial assets, generally.
"It's hard to see the U.S. dollar not rising when the Fed is the only central bank tightening monetary policy," Sterne said.
These negatives are arguably already priced into emerging markets assets. It's a question of how events play out relative to expectations.
"The speed of the change in U.S. monetary policy is uncertain," said Ribe at Macro. "If it doesn't happen as fast as people expect, emerging markets will do better. If it happens faster, it could be a drag on performance," he added.
Ric Edelman, founder and CEO of Edelman Financial, suggests investors not try to handicap central bankers' behavior, nor try to time investments in emerging markets based on economic forecasts.
"We discourage investors from thinking about emerging markets opportunistically," said Edelman, who invests in passively managed ETFs that track market indexes. "They should maintain a stable, long-term position and rebalance to targets."
His target allocations for clients are relatively low. He typically allocates between 0 percent and 5 percent of a client's assets to emerging markets based on their appetite for risk.
"Emerging markets are a risky and volatile asset class," Edelman said. "We believe in holding a position in them, but we limit it because of the volatility. It's a risk we feel we just aren't very well compensated for."
Vanguard Group's Aliaga-Diaz, however, suggests that U.S. investors should be increasing allocations to emerging markets in line with these countries' growing share of global market capitalization.
"We're not overly optimistic, but we're also not pessimistic," he said. "On a long-term basis, emerging markets are still growing faster than developed markets."
— By Andrew Osterland, special to CNBC.com