Emerging markets are so far among the strongest stock plays of 2017, easily outperforming other regions and assets, and bulls are betting the upward momentum will continue. The region has long been an underperformer relative to U.S. markets—it continues to trade under its pre-financial crisis peak, whereas Wall Street has set dozens of records over recent years—but emerging market stocks have outperformed in 2017. The Vanguard FTSE Emerging Markets ETF VWO, +0.11% is up 23.3% thus far this year, more than twice the 9.2% rise of the S&P 500 SPX, +0.46% The iShares MSCI Emerging Markets ETF EEM, +0.16% is up more than 27% in the year to date, while the iShares Core MSCI Emerging Markets ETF IEMG, +0.22% is up 26.7%.
The divergence between the two emerging-market ETFs comes because they track different indexes with different components and constructions. The noncore iShares fund, for example, counts Alibaba Group Holding Ltd BABA, +2.29% as one of its largest components; the stock is up more than 90% thus far this year and isn’t a component of the FTSE index that Vanguard’s fund tracks.
While the two funds have performed differently, the overall trend in the region has been positive, and the gains have taken it above what LPL Financial described as a “10-year bearish trendline.” Ryan Detrick, the firm’s senior market strategist, said that was “yet another sign that the EM strength is real and could continue.”
Detrick didn’t indicate what kind of upside potential was likely following the breakout he described, but he also noted that the region looked strong on a relative basis. “After lagging for many years, there has been a significant breakout to two-year highs in the MSCI Emerging Markets Index relative to the S&P 500,” he wrote in a note, calling this “another indicator that the EM strength could be legitimate and should continue to be a place to find potential alpha in well-diversified portfolios.”
Alpha refers to outperformance relative to traditional benchmarks like the S&P 500 or the Russell 2000.
While technical factors can dictate market direction in the short term, longer moves are predicated on fundamentals, something that Detrick also said supported emerging markets, a region that is typically seen as riskier and more volatile, while offering the potential for higher growth. “What makes the recent strength in emerging markets encouraging is that we’ve also seen a big pickup in corporate earnings, and valuations are still modest relative to the rest of the world,” he said.
In a sign of how emerging markets have led among non-U.S. stock categories, the ETFs have also outperformed the broader Vanguard FTSE All-World ex-US ETFVEU, -0.19% which looks at all global stocks, excluding the U.S. That fund is up 17% in 2017.
The strength in the region comes at a time when U.S. valuations are stretched, according to many metrics. By one calculation, the U.S. is the most expensive market in the world. In that environment, investors and analysts have increasingly looked to overseas markets for upside potential.
Based on the components of the EEM iShares fund, emerging market stocks have a price-to-earnings ratio of 25.12, along with sales growth of 6.55% and a dividend yield of 2%. The S&P has the same dividend yield and modestly higher sales growth—6.87%—but it trades at a much more expensive valuation, with a P/E of 30.8. Investors have been moving into emerging market funds this year. Vanguard’s ETF has had $6.8 billion in year-to-date inflows, while $2.4 billion has moved into the iShares fund, according to FactSet. The core iShares fund has had nearly $12.5 billion in inflows, the fourth highest of any equity ETF.
According to Hedge Fund Research, investors allocated new capital to EM hedge funds for the first time since the second quarter of 2015 in the second quarter of this year. EM funds had $800 million in net new inflows, while overall EM capital increased by $7.5 billion in the quarter. Total EM hedge fund capital grew to $213.3 billion, the fourth consecutive quarterly record.