Emerging markets look attractive - but tread with caution

As US equities continue to rally ahead of a volatile election with valuations remaining lofty and a virus that is far from under control, the case for equity diversification is growing and emerging markets are starting to attract greater attention.

Major emerging market economies such as Brazil are starting to finally get a foothold on the virus and, as equity valuations remain attractive - at least on a relative basis - emerging market equities have been rising in recent days and could be set to outperform their developed market peers.

Morgan Stanley's emerging market strategists noted last week that they were tempted to buy emerging market assets and have been "dipping their toes" in given their cheaper valuations and an improved outlook in 2021. They also note that the region is benefitting from a wider Democratic lead in the polls as it implies a lower likelihood of the results being contested by Trump (and it should be mentioned that EM-US relations are likely to be more positive under a Democratic victory), whilst receiving a lift should there be another U.S. fiscal stimulus package.

Murat Ulgen, global head of emerging markets research at HSBC also noted that global liquidity, technical positioning and improving investor sentiment from their recent EM survey points to a positive outlook for equities in the region.

However, as positive as the outlook may appear, both analysts voiced reason to be cautious before going all-in. Morgan Stanley view the U.S. election as a potential headwind given the uncertainty and volatility that surrounds the event, whilst Ulgen points to limited capabilities for policy makers to further ease monetary policy, possibilities of weaker EM currencies, the risk of inflation, as well as disruptions to supply chains. Given central banks within emerging markets have already cut rates totalling 4000 basis points according to Barron's, unconventional monetary policy such as QE we've seen in developed markets could be brought into play which may weaken currencies, hurt equities and potentially lead to inflationary pressures.

When talking about emerging markets, one must not forget that Asian exposure now accounts for c.70/75% of most funds and so it is the progress in Asia that is set to dictate overall performance for EM investors. With China and Asia more broadly having the virus under much greater control and not having to throw as much stimulus at their economies, these funds are able to provide some extra protection for those putting money to work in emerging markets.

Regardless of whether investing in a broad EM fund with Asian exposure or selecting an ex-Asia option, investors in the region will be sitting tight ahead of November 3rd and hoping that the polls are right. A Trump victory is likely to come with greater tariffs and harsher relations with China - and right now, this is something emerging markets could do without.