Good reasons to be bullish on Emerging Markets right now

Emerging markets have been a huge disappointment in recent years, but headwinds facing the U.S. and very compelling valuations relative to developing markets could make investment in these regions attractive for patient investors who can stomach the extra risk.

Investors have become skeptical of “submerging markets,” and for good reason. The S&P 500 Index has posted a three-year annualized return of 16.6%, while the iShares MSCI Emerging Markets ETF (EEM) is slightly negative over the same period. The so-called BRIC nations of Brazil, Russia, India and China have been a disaster this year, and weak currencies against the dollar have also taken a toll.

Yet there are signs that at least some investors are beginning to rotate back into emerging markets as the U.S. wrestles with the government shutdown and worries over the debt ceiling and a potential debt default linger. The iShares MSCI Emerging Markets ETF (EEM) is up about 12% the past three months to more than double the return of the S&P 500. The chart below shows the relative performance of the emerging market ETF versus the S&P 500 with the recent bounce.

The September rebound in emerging markets may have been driven by a shift in expectations regarding the Federal Reserve and quantitative easing. Developing markets benefit from loose central bank monetary policies since they rely on overseas investment. Tighter credit and rising interest rates tend to hit them harder than in the developed markets.

The underperformance relative to the S&P 500 started accelerating in May when Ben Bernanke first floated the idea of the Fed tapering its bond purchases if the economic and employment data warranted such a move. However, emerging markets started bouncing back in September even before the Fed announced its no-taper decision. The unemployment rate was 7.3% in August, above the Fed’s stated 6.5% goal. The U.S. economic recovery remains weak and the government shutdown could make the Fed even more likely to postpone tapering.

So a shift away from tapering expectations to more Fed quantitative easing may provide a tailwind for emerging markets relative to developed.

But investors who want to step up and buy this loathed asset class should be in for the longer haul. Emerging markets shouldn’t be a short-term trade.

For long-term investors, other positive factors for emerging markets include faster economic growth, less debt and a rising middle class. In July, the International Monetary Fund forecasted that advanced economies will grow 1.2% in 2013, compared with 5% for emerging and developing markets.

The lagging performance of emerging markets in recent years may have also created a current bargain for investors with a long time horizon. J.P. Morgan Asset Management points out that the bleak headlines for emerging markets have pushed average valuations down to levels that have signaled attractive buying opportunities the past two decades. The iShares MSCI Emerging Markets ETF (EEM) has a price-to-book ratio of 1.36, compared with 2.19 for SPDR S&P 500 ETF (SPY), according to Morningstar.

Of course, valuations can always fall further, which is why investors need to take a long-term perspective with emerging markets, which are known for their volatility. The iShares MSCI Emerging Markets ETF (EEM) has a 10-year standard deviation of 23.8 versus 14.7 for the SPDR S&P 500 ETF (SPY). So investors should be prepared for a potentially rocky ride due to higher geopolitical and currency risks, among other challenges. Also, investors seeking to boost returns with emerging markets may want to consider limiting the allocation to a relatively small slice of the overall portfolio, perhaps less than 10%.

Emerging markets may fall harder during periods of global uncertainty, but attractive valuations and favorable macroeconomic trends could make the sector an appealing long-term addition for investors willing to take on the risk. Successful contrarian investors know the best time to buy asset classes is when they are unloved, and emerging markets currently fit the bill after several years of dismal returns. Yes, investors who bought emerging markets three years ago as a growth play have essentially broken even. But right now developing markets appear to be at bargain levels that have provided a reasonable margin of safety the past two decades.

All investments involve risk and various investment strategies will not always be profitable. International investing involves special risks, such as political instability and currency fluctuations. Past performance does not guarantee future results.