Emerging market stocks are off to a strong start in 2023 — How the outlook is shaping up

Published Thu, Jan 19 202310:00 PM ESTUpdated Fri, Jan 20 20233:47 PM EST

Emerging market stocks are off to a strong start in 2023, even as concerns remain for investors. Emerging markets have underperformed in the past two years, as a rising dollar, interest rate hikes from central banks around the world, and the ongoing impact of the pandemic dented growth. The iShares MSCI Emerging Markets ETF (EEM) tumbled more than 22% in 2022, and more than 5% the previous year. This year, however, that picture appears to have changed. The EEM has advanced more than 8% this year, compared to the S & P 500's rise of 1.5%. Cheaper valuations have made emerging markets equities attractive to investors, as a weaker dollar, easing inflation, and a reopening in China, are expected to be a boon to these assets. "One of the primary attractions for emerging markets has been compelling valuations," said LPL Financial's Quincy Krosby. "Again, they were neglected. They were, except for again, Brazil did well, India did well, they were essentially neglected by portfolio managers." Still, investors differ on the outlook for emerging markets from here. Outlooks Carlos Asilis, co-founder and chief investment officer at Glovista Investments, has a bullish outlook on emerging markets equities, and recommends investors take an overweight stance. Should emerging markets equities represent a 10% benchmark allocation in the global equity index, Asilis said investors should take about a 12% weighting. For investors with a higher risk tolerance, that allocation could go as high as 20%, he said. "I would say 12%, 11% is almost neutral, right? It makes sense to be at least 12%. And then, maybe between 12% and I would say 16% makes sense," Asilis said. He added that most investors may find this to be a reasonable exposure level. Others took a more measured stance. BCA Research's Arthur Budaghyan said he does not expect the current rally in emerging markets to be sustainable, and he urged investors to wait on the sidelines for a better opportunity later this year. He anticipates that emerging markets' outperformance could stall or partially reverse in the next couple of months. But it could prove fortuitous for investors wanting to get in later this year. "I think that we'll be getting a greater buying or overweighting opportunity sometime in the middle of this year for second half," Budaghyan said. He expects that a reopening in the Chinese economy will pick up more meaningfully in the second half, boosting economies in emerging markets. Further, slowing growth in those economies, stemming from tighter monetary policy, could reverse later this year as well. EEM .SPX YTD line iShares MSCI Emerging Markets ETF vs. S & P 500 year to date Budaghyan recently opened an upgrade watch on emerging markets, but remains underweight on them within the global equity portfolio. He expects investors are better off keeping their cash in money markets or global bonds over the next several months. Meanwhile, LPL Financial's Krosby said that the rally in emerging markets could be short-lived, saying any increased level of liquidity could drive up valuations to a less compelling level. "Any suggestion that the market has the Fed wrong, any suggestion that the Fed is actually going to maybe move to 50 basis points as opposed to the probability of 25 basis points … that would put a bid on the U.S. dollar," Krosby said. Not all emerging markets are equal Even as emerging markets are broadly outperforming, some countries are expected to perform better than others. Many market participants expect that China equities will beat peers this year — in spite of some lingering concerns around travel. "A lot of our peers have been massively underweight China, and they've underperformed dramatically last year and the beginning of this month, so I think there's a lot of buying of Chinese equities that looms ahead," Glovista's Asilis said. The iShares MSCI China ETF (MCHI) is up more than 12% this year, after falling 24% in 2022, and 22% in 2021. Other markets Asilis finds attractive are Southeast Asia, Taiwan, South Africa, as well as Brazil. Meanwhile, BCA's Budaghyan said he would be overweight Mexico. While the country has exposure to the U.S., which Budaghyan has a negative outlook on, it has exposure to the auto sector. The iShares MSCI Mexico ETF (EWW) is up more than 13% in 2023. Budaghyan added that Mexico is leveraged to an area of the U.S. that's still seeing strong demand —that's because previously supply shortages made it difficult for people to purchase cars. The strategist also favors exposure to South Korea and Chile. The iShares MSCI South Korea ETF (EWY) and the iShares MSCI Chile ETF (ECH) are up more than 10% and nearly 1%, respectively. One sector that Budaghyan would avoid is Chinese tech companies such as Alibaba, Baidu and Tencent. The strategist has concerns over the long-term outlook for these firms, given increased government involvement in the businesses.