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Fear be damned: This is the time to invest in emerging markets

February 3, 2014: 5:00 AM ET

The panic-driven selloff has led to the buying opportunity of a lifetime.


FORTUNE -- Never underestimate the impulse for Wall Street market strategists and pundits to spin an outbreak of sudden fear into a durable trend, with a sensible-sounding narrative to back it up. So it is today with the sharp selloff in emerging market stocks and bonds. For champions of U.S. equities, indeed, the panic overseas seems a timely gift. Talk up the chill in China's growth machine -- now throw in some turmoil in Turkey -- and suddenly the notion of paying a fat premium for U.S. stocks seems downright reasonable. After all, if America is once again the bastion of safety, then its stocks should command far more handsome valuations than shares in the unstable developing world, no?

As fear spreads to one emerging market after another, that argument becomes at least temporarily self-fulfilling. But sooner or later, logic catches up with the investing world. The first investors to figure that out usually do pretty well.

To explain, though, let's start with the fear: In China, the world's greatest engine of growth, output is genuinely, if modestly slowing. Separately, excessive monetary stimulus in Argentina, India, and Turkey has caused a dangerous surge in inflation that has led citizens and companies to flee their currencies for dollars and euros. To stem the flight of capital, all three nations have sharply raised interest rates. On Jan. 29, the Turkish government took extraordinary action, lifting the rate on overnight borrowings to a punishing 12%, from its previous level of 7.75%.

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It's hard to define precisely why investors are so worried, given that the economic stories around the globe are so divergent, and investors are expressing such a cacophony of concerns. But a major issue appears to be fear about the potential effects of the U.S. Federal Reserve's imminent "tapering" of its long-running stimulus program. The Fed's quantitative easing at home (which kept interest rates artificially low) encouraged capital to flow from the developed world to the emerging one. The fear is that as the Fed pulls back on its stimulus, the global capital flow will swiftly change direction.

The European Central Bank (ECB), likewise, kept interest rates low in Europe. The Bank of Japan did the same in Japan. As the surge in monetary growth lowered rates across the developed world, investors sought higher yields on sovereign and corporate debt in nations from Indonesia to South Africa. "Folks sold dollars to buy bonds in Brazilian reals," says Chris Brightman, head of investment management at Research Affiliates, a firm that oversees strategies for $166 billion in investments. Those bonds frequently paid two or three times the coupon on Treasuries.

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Investors, of course, are always looking toward the future. What many foresee is a dramatic reversal in capital flows: As the Fed presses gently on the brake pedal this year, many believe money will rush back to the U.S to profit from rising rates. That, in turn, would depress the value of emerging market currencies -- which would be precisely the opposite trend of the last half-decade.

Capital outflows can indeed prove damaging. If a Turkish developer borrows in euros and dollars to build a manufacturing plant or an apartment complex, and the lira drops by 25% against those currencies, the developer would require far more lira to cover the interest payments. That could lead to bankruptcies and restructurings. That scenario is what investors seem to fret most about.

But there's a good chance -- for reasons outlined below -- that the shifting tide of capital flows won't be the sea change that investors fear. The shift in tide might even help emerging nations more than it hurts them. After all, the flood of cash over the past five years swelled the value of emerging market currencies. As a consequence of that, the export prices of things like Brazilian sugar and computer components from India (traded in dollars or euros) rose sharply. That trend hammered the competitiveness of manufacturers in the developing world in the battle for market share with European and U.S. producers.

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A return to currencies whose value is set by market forces, rather than heavy-handed intervention, could actually be a boon to emerging markets.

A second worry right now is that, as inflation spikes in the developing world, governments will be forced to severely tighten their grip on monetary policy, a stance that might also be necessary to protect their currencies. That would lead to a contraction of credit, and might slow future growth.

Again, the danger is exaggerated. Falling currency values would make the developing world's exports cheaper vs. those of the U.S. and Europe. That's what those nations have wanted for years, isn't it? Any improvement in competitiveness, in fact, is likely to outweigh the damage to companies facing higher costs on their borrowings in euros or dollars.

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But in the bear scenario that reigns today, it's a double whammy of lost competitiveness and higher rates to come. Or triple whammy if you count widespread panic as its own whammy.

Enter reality. Yes, in reality, the emerging markets -- taken as a whole -- aren't any more dangerous than the generally profligate developed world. "That notion is an illusion," says Rob Arnott, CEO of Research Affiliates. "Do I buy what's expensive, where the reality is really worse than advertised -- meaning U.S. stocks and bonds?" Arnott frames the question. "Or do I buy a market that is cheap and perceived as troubled, where the reality isn't nearly as bad?"

And when Arnott says "cheap," he means cheap. According to his analysis, emerging market stocks at current prices represent the best buying opportunity, anywhere, any time, in any asset class, since the mini-crash of 2011.

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The latest crash in emerging market shares follows on years of poor market performance. Since the start of 2014, the iShares MSCI Emerging Market index (EEM) has tumbled 8.8%, vs. 4% for the S&P 500 (SPX). Even in 2013, a year when the S&P rose 29.6%, the EEM slipped 5.7%, and investors have suffered negative returns for more than three years. That sorry record of swooning (as the developed world was soaring) is precisely what has made the category so cheap.

Yet the growing gap in valuations is totally unsupported by the fundamentals. In general, the emerging markets economies are not only growing faster than the developed world, but are growing in a more fiscally disciplined way. (More on that in a bit.) These countries have younger populations and a greater abundance of natural resources than the developed countries of Europe and North America. The BRICs -- Brazil, Russia, India, and China -- generate 22% of the world's GDP, and owe only 5% of the sovereign debt.

By contrast, the developed countries control 62% of global output, and pay interest on 90% of the government bonds. With fast-growing workforces and ample supplies of crops and minerals, the developing countries are in a stronger position to cover their future interest burdens, and hence channel more of their future growth into private investment, than many western nations are. Few developing nations shoulder total debt exceeding 50% of GDP. For the emerging economies, Brazil is a huge borrower with debt to GDP of around 68%. By contrast, most of the big western economies -- including France, Italy, the U.K., and Germany -- carry burdens of between 80% and well over 100%. Japan's ratio, for that matter, tops 200%.

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The emerging economies further benefit from a powerful demographic tailwind. The developed world is graying rapidly. In Europe, the working population will remain stagnant in the decades to come, and the U.S. workforce is expected to expand at just 0.6% over the next 20 years, less than half the rate of the past four decades. By contrast, the population of engineers, farmers, and computer programmers in the emerging markets are likely to grow 1-2% per year, far faster than their counterparts in the developed world.

That demographic dividend -- ensuring that the ranks of newly productive folks will outrace the rise in retirees -- will greatly enhance these nations' growth in the decades to come.

Given those strong fundamentals, it's nonsensical that emerging markets have been hammered as badly as they have.

The good news for investors willing to ignore the nonsense is that these stocks, on the whole, are selling at a gigantic discount to U.S. shares.

Right now, Arnott reckons that emerging market stocks are trading at a multiple of 11 times earnings. But he advises using a different measure based on economist Roberts Shiller's CAPE (for "Cyclically Adjusted Price Earnings") Ratio. The CAPE adjusts for the erratic spikes and valleys in profits by using a 10-year average of inflation-adjusted earnings to calculate a more realistic P/E, one that better reflects long-term trends in profitability.

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Emerging market earnings are running a bit above historic averages right now, so their CAPE is around 13. For comparison, the CAPE for the S&P 500 stands at about 25.

That's a remarkable reversal from 2007, when the emerging markets had a CAPE of 37, vs. an S&P CAPE of 26. "For every $100 you invest, you're getting $8 in earnings and $3 in dividends," says Arnott. "Compare that to the S&P, where you get $4 in earnings, and less than $2 in dividends! When you start with a CAPE of around 25, returns over the next 5 years tend to be 0.5% a year."

On the other hand, says Arnott, buying at a CAPE of 15 or below produces average annual returns of 16% over the ensuing half-decade.

It's unlikely that emerging market stocks will generate returns that big -- and it may take a while to break out of the current vise grip of panic. (That's just the way markets work.)

But emerging market stocks are so cheap that double-digit returns over the longer term are probable. So think about adding a whole new emerging markets pillar to your investment portfolio. And instead of getting scared if prices fall further, you might want to buy more. The combination of a flurry of bad news from emerging markets and some old-fashioned groupthink on Wall Street has handed investors a rare opportunity.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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