The MSCI Emerging Markets Index (MXEF) has declined 12 percent this quarter on fears that Europe’s sovereign debt crisis is worsening. The gauge trades at 9.9 times estimated earnings, compared with an 11.8 multiple for the MSCI World Index (MXWO).
Valuations in emerging markets are near 10-year lows (excluding 2008), an indication of slowing gross domestic product (GDP) growth rates and manufacturing activity. Emerging markets’ trailing 12-month price-to-earnings multiples are also near five-year lows relative to that of the S&P 500.
Most GEMs enjoy flexibility in adjusting their monetary and fiscal policies to boost growth, while at the same time inflation risks have abated. If global economic volatility retreats to more typical levels, low valuations and governmental stimulus measures should support improving GEM performance in 2012. At current levels and barring contagion in Europe, the GEMs could return 30 percent by the end of the year.
The easiest way to capture the upside from these trends is to invest through exchange-traded funds (ETFs). Based on valuations and the inherent strengths of their economies, China and South Korea look particularly attractive. The era of double-digit GDP growth in China is over, as the country tries to stabilize and increase the number of people that can participate in economic growth. As a result, growth of 8 percent should be seen as positive for China’s future because it reflects a sustainable pace.
The country is trying to enhance the quality of its growth, by stimulating domestic demand and lessening the economy’s dependence on exports. Despite the overblown fears expressed by analysts, a hard landing for China this year is not likely.
If European and U.S. woes deepen and China’s rulers decide that significant stimulus is necessary, the country will have plenty of leeway. Total government debt in the country stands at less than 40 percent of GDP, a figure most other countries would envy.
Despite these encouraging trends, negative investor sentiment predominates, which poses a contrarian opportunity.
The iShares FTSE China 25 Index Fund (FXI) captures the performance of the biggest Chinese companies that trade in Hong Kong. It also offers exposure to companies that are trading at valuations very close or even below their 2009 lows. These include Chinese banks, some telecoms and Chinese oil companies.
For more aggressive investors seeking exposure to the Chinese market, the best bet is the Market Vectors China ETF (PEK). The fund tracks the CSI 300 Index, a local market capitalization-weighted index designed to capture the 300 largest and most liquid stocks.
South Korea, Asia’s fourth-largest economy, has undergone rapid consumer growth, while government spending and investments by semiconductor chip makers is boosting the economy.
South Korea is home to competitive and well-managed companies that have yet to see their valuations rise to reflect their underlying fundamentals. In particular, Samsung Electronics (Korea: 005930, OTC: SSNLF) and Hyundai Motor (Korea: 005380, OTC: HYMTF) have emerged as strong enough to dominate their respective industries.
The iShares MSCI South Korea Index Fund (EWY) offers solid exposure to some of the best companies in South Korea. For more emerging market picks, check out my Best Asian Stocks to Buy Now report.