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Merrill, Wells Fargo, LPL See Emerging Markets Gaining Steam

By Murray Coleman December 1, 2017

To a growing chorus of advisors, weakness in junk bonds is sending ominous signals for U.S. stock investors. But even if domestic shares fade, analysts at major brokerages are pointing to one possible source for longer-term optimism: emerging markets.

“Emerging markets stocks are up around 35% this year, but we still see reason to believe that this rally has legs,” says Ryan Detrick, senior market strategist at LPL Financial.

The independent broker-dealer earlier this week issued its 2018 market outlook for its affiliated advisors and their clients. “Even with a big jump in prices over the past 12 months,” Detrick says, “we see emerging markets as an asset class that longer-term investors need to overweight as part of a globally diversified portfolio.”

The MSCI Emerging Markets Index’s trailing 12-month price-earnings ratio, a key valuation metric, is hovering around 15.5, he notes. That’s “slightly” more than its 10-year average, he adds. “But you buy emerging markets to gain exposure to long-term growth characteristics, not for their appeal as relative bargains,” Detrick says.

By year’s end, he projects emerging markets stocks will produce average earnings growth of about 24%. Next year, he sees an annualized rate of about 14%. “But that’s pretty strong compared to much of the rest of the world,” Detrick says.

LPL is forecasting that developed international markets will gain about 8% in 2018, with U.S. stocks rising by around 11%. “Emerging markets are coming off five years of lagging performance where companies were mired in an earnings recession,” Detrick says. “But we think this asset class is now ready to enter the second or third inning of a new secular bull market.”

Volatility is a constant for stock investors, particularly in emerging markets. For two years through 2006, for example, MSCI benchmarking data show emerging markets produced more than twice the rate of standard deviation — a common measure of market volatility — as U.S. stocks.

Worth noting is that the MSCI index for emerging markets gained an average annualized 14.7% in the decade of the 2000s. At the same time, domestic stocks as tracked by the MSCI USA Index rose by 0.43%.

“Emerging markets as a group are becoming a bigger part of the global economy and more difficult to ignore,” says Niladri Mukherjee, managing director at Merrill Lynch Wealth Management. “The global growth engine is increasingly moving toward places like China and India.”

With emerging markets home to 85% of the world’s population and responsible for more than half of global output, “We’re expecting almost twice as fast real GDP growth in developing economies next year as in the U.S.,” says Mukherjee.

Next year, he thinks emerging-market earnings growth will top 20%. In the U.S., Merrill Lynch is projecting corporate profits on average to increase between 8% and 10%.

Headwinds do exist, however. Mukherjee warns that any resurgence of inflation or tax-reform legislation in the U.S. that’s "too simple" could dampen global growth.

“But we certainly think that emerging markets can continue to outperform over the next several years,” he says, “and our longer-term view remains quite sterling.”

Peter Donisanu, a Wells Fargo investment strategist, is forecasting much the same. But as investment returns move to less overheated levels in the future, he says being more selective will prove particularly beneficial for both strategic and tactical investors.

Niladri Mukherjee

Heading into 2018, Donisanu and his colleagues like fundamentals for larger developing Asian markets like China, India and Taiwan. He also favors Russia, South Africa and Poland.

“Historically, emerging markets are fundamentally more volatile,” Donisanu says. “We do see this rally as having legs, but like in the U.S. we see these stocks as primed for a pullback as investors become less comfortable with taking risks.”

Rather than looking at a specific timeframe for such a slide, he’s watching for a “catalyst” or “risk-off” event. This could be anything from heightened tensions between the U.S. and North Korea to major trade policy disputes with China, Mexico or Canada.

“Barring these types of unforeseen market disruptions, we believe that economic growth will continue across emerging markets at least through 2018,” Donisanu says.

No matter what happens in the short-term, emerging markets will remain a core holding for most clients of advisor Jeff Carbone. The managing partner at Cornerstone Financial Partners in Charlotte, N.C., which manages $850 million, says his message to high net worth investors is that logically another “breather” in growth and another “bout” of volatility will come at some point.

Earlier this year, Carbone increased his typical client’s emerging markets allocation to 7% of equities.

“No matter what market conditions prevail over the next year or two, we always like for our clients to maintain exposure of around 3% to emerging markets,” he says. “So while we’re not expecting to see returns topping 30% next year, we still see a case for overweighting this asset class in anticipation that growth will continue at a relatively strong pace.”