When making investment decisions, it makes sense to watch the big trends and try to bet when and where the probabilities are on your side. Flexible liquidity conditions, attractive valuations with improving economic growth, and vigorous price momentum are three strong tailwinds for emerging markets right now.

1. Global Liquidity Is A Powerful Driver For Emerging Markets

When evaluating emerging markets stocks as a global asset class, it is of utmost importance to pay close attention to economic policies in the United States and other big economies. Global liquidity is a major return driver for stocks all over the world, and particularly more in emerging markets.

When liquidity is contracting and interest rates are rising in the United States, this attracts capital to the U.S. and the dollar tends to appreciate. An appreciating US dollar tends to hurt commodity prices and economic growth in many emerging markets.

Money flows away from emerging markets when global liquidity is contracting, and the problem is often exacerbated by pro-cyclical economic policies in those countries. Economic activity slows down, which hurts tax revenue, and rising credit spreads make the cost of debt more expensive.

For this reason, many emerging markets are forced to implement fiscal budget cuts and raise interest rates in times when they should, in fact, be going in the opposite direction to alleviate the recessionary pressures from contracting global liquidity and an appreciating U.S. dollar.

Conversely, when liquidity is expanding and interest rates in the U.S. are declining, global investors tend to go hunting for higher returns in other emerging markets. International capital flows create a virtuous cycle for emerging markets: economic growth accelerates, the cost of debt declines, and local currencies tend to appreciate. This can clearly provide a big boost to stocks in those countries.

Like Warren Buffett said, "A rising tide lifts all boats," but some boats tend to rise more than others, and emerging markets are among the biggest beneficiaries from accommodative liquidity conditions on a global scale.

Monetary policy in the US, Europe, and China is being far more flexible in recent months. If history is any valid guide for the future, this should be a major positive for emerging markets stocks going forward.

From a research article by MRB Partners

The Fed’s recent U-turn to a dovish tilt, followed by the ECB pausing on its commitment to monetary normalization, and the Chinese authorities’ bias towards reflation (albeit primarily fiscally-driven, rather than via a monetary easing) add up to a supportive backdrop for global hot money flows. Carry trades continue to support EM currencies, reducing domestic bond yields, and attracting strong inflows into EM equities.

2. Attractive Valuations And Improving Fundamentals

The chart from Franklin Templeton shows the evolution of relative price to earnings and price to book value ratios for emerging markets stocks versus global stocks over the past several years. An image is worth a thousand words, and emerging markets are clearly undervalued by historical standards.

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Source: Franklin Templeton

The valuation gap between US stocks and emerging markets stocks is quite staggering at current prices. The table shows key valuation metrics for companies in SPDR S&P 500 (SPY) versus iShares MSCI Emerging Markets ETF (EEM), and it's easy to see how emerging markets are priced at bargain-low levels by all the metrics considered.

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Source: Morningstar

Valuation can be a crucial variable over the long term, but sometimes you need a fundamental driver for the lower valuations to be reflected on superior gains for a particular market in the medium term.

Interestingly, economic data in emerging markets is coming in materially ahead of expectations in recent months, as reflected by the Citigroup Economic Surprise Index for emerging markets. As long as this trend remains in place, it can be expected to be a strong tailwind for emerging markets stocks in the coming months.

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Source: Forbes

Money has an opportunity cost. You don't just want to bet on stocks that are doing well, you also want to buy the stocks and markets that are performing better than others. The chart from MRB Partners with data from Markit Economics shows the relative evolution of economic activity in emerging markets versus developed markets.

Not only is the economy in emerging markets starting to perform better than previously expected, but the relative growth rates are favoring emerging markets in comparison to developed countries in recent months.

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Source: MRB Partners

Emerging markets stocks are much cheaper than stocks in the US, and improving economic data could be a catalyst for this valuation to be reflected on superior returns for emerging markets stocks over the coming months.

3. The Trend Is Your Friend

Winners tend to keep on winning in the stock market, and there is plenty of academic research proving that investors can obtain market-beating returns by investing in different asset classes when they are showing superior relative strength.

The Asset Class Rotation Strategy is a quantitative strategy. This system rotates between 9 ETFs that represent some key global asset classes.

• SPDR S&P 500 for big stocks in the U.S.
• iShares Russell 2000 Index Fund (IWM) for small U.S. stocks
• iShares MSCI EAFE (EFA) for international stocks in developed markets
• iShares MSCI Emerging Markets for international stocks in emerging markets.
• Invesco DB Commodity Index Tracking (DBC) for a basket of commodities
• SPDR Gold Trust (GLD) for gold
• Vanguard Real Estate ETF (VNQ) for REITs
• iShares 20+ Year Treasury Bond (TLT) for long-term Treasury bonds
• iShares 1-3 Year Treasury Bond (SHY) for short-term Treasury bonds

In order to be eligible, an ETF has to be in an uptrend, meaning that the current market price is above the 10-month moving average. If no ETF is in an uptrend, the system goes for the safest asset in the group, which is iShares 1-3 Year Treasury Bond.

Among the ETFs that are in an uptrend, the system buys the top 3 with the highest relative strength. Relative strength is measured by a ranking system that considers total returns over 3 months and 6 months, and it includes volatility as a negative factor. The benchmark is a globally diversified portfolio that is allocated 60% to stocks and 40% to fixed income.

Backtested performance numbers are quite strong. Since January of 2007, the strategy gained a cumulative 315.5% versus 90.8 for the benchmark. Annual return is 12.4% for the strategy versus 5.4% for the benchmark over that period.

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Source: ETFreplay

Since the strategy goes for safety during bear markets, it is quite effective at protecting the portfolio when stocks are moving in the wrong direction. The maximum drawdown is 14.4% for the strategy versus 35.4% for the benchmark.

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Source: ETFreplay

It's important to understand that a quantitative strategy such as this one has both its strengths and limitations. Momentum cuts both ways, and investments that are delivering superior gains can also fall harder than others if market action turns around.

The strategy is buying strength and selling weakness, so it tends to perform well when there are well-defined trends in different asset classes. In times of sideways market action and short-lived trends, a momentum-based strategy should be expected to deliver disappointing results.

The strategy is also based on momentum metrics over 3 and 6 months, which can be described as a medium-term horizon. When there are quick changes in market conditions, it takes some time for the strategy to incorporate the new data into the portfolio recommendations, and this can have a negative impact on results.

Those limitations being acknowledged, investment decisions based on time-proven and quantified return drivers are clearly much sounder than those based on opinions and speculation. Besides, quantitative momentum data is very valuable in terms of analyzing the market environment for different assets.

Looking at the risk-adjusted momentum indicators, emerging markets are the top asset class among the 9 considered in the Asset Class Rotation strategy. In terms of price action over the medium term, the timing looks good for emerging markets stocks.

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Source: ETFreplay

The Bottom Line

The bullish thesis for emerging markets depends on several factors going forward. If the idea is going to play out well, then emerging markets stocks need liquidity levels to remain supportive and economic growth trends to remain healthy.

A major risk factor for emerging market stocks is the trade war with China and its potential implications on a global scale. Such uncertainty factor is already reflected on stock prices to a good degree, and investors are arguably getting used to lots of coming and going with little material progress in the negotiations. However, if we see an escalation in the trade war, with increased tariffs and similar measures, this could be a major setback for emerging markets.

In spite of that risk, the main point is that favorable liquidity conditions, bargain-low valuation levels with improving economic growth, and vigorous price momentum are several key reasons to consider a position in emerging markets over the medium term.