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Emerging markets are climbing back from the dead

Posted September 15

— Stocks and bonds from Thailand, Indonesia and other developing economies are emerging from their burrow.

After ranking as some of the world's worst investments the last few years, emerging markets have produced some of the best returns of 2016. Gains have been so big for Brazilian bank Banco Bradesco, Chinese technology giant Tencent and emerging-market stocks in general that the average mutual fund invested in them has returned 11.5 percent this year. That's roughly double the return of S&P 500 index funds. Returns for emerging-market bond funds, meanwhile, have been even higher, at 12.1 percent, through Wednesday.

Of course, the big gains mean emerging-market investments have clawed back only a portion of their bigger losses from prior years. The largest such mutual fund by assets, Vanguard's Emerging Markets Stock Index fund, is still down 12.4 percent from two years ago, even after including dividends. Many risks also still hang over emerging-market investments, not least of which is a history of following big swings up in price with big swings down. It's a notoriously volatile corner of the market, but mutual-fund managers and analysts say they see reason for continued gains.

Investors are buying in. They plowed nearly $13 billion into emerging-markets stock funds in the first seven months of this year, with roughly half of that coming in July alone. They've also put $5.5 billion into emerging-market bond funds, a sharp reversal from last year, when they withdrew nearly $10 billion.

The dollars are moving at a time when investors and fund managers see U.S. stocks near record highs and Treasury yields close to record lows and wonder how much more return, if any, can be squeezed from them.

"Investors are running out of places to go and giving laggards a chance," notes Brian Nick, chief investment strategist of TIAA Investments.

If the growing demand for emerging-market stocks and bonds turns into a mass migration, it would be only the latest flip of the switch for global investors. Before the global financial crisis in 2008, emerging markets were some of the hottest investments. Led by an ascendant China, their economies were growing faster than the rest of the world and seemed more dynamic. But emerging-market stocks fell more sharply in the aftermath of the financial crisis. As recently as the start of this year, worries were flaring that China wouldn't be able to manage its slowdown in growth.

Among the encouraging signs analysts cite for emerging markets now are:

— Better bargains

Fund managers say nothing in the world looks cheap, but stocks from developing economies look less expensive than stocks in the U.S. and other areas of the world.

Analysts often measure how expensive a company is by measuring its stock price against how much profit it makes. By that measure, emerging-market stocks recently were about 15 percent cheaper than their developed-market counterparts, according to Credit Suisse.

— Greater growth

Economies around the world have been stuck in a slow-growth recovery since the financial crisis. The U.S., German and other advanced economies will likely see growth tick down to 1.8 percent this year and then stay there in 2017, according to the latest forecast from the International Monetary Fund.

At the same time the IMF downgraded its forecast for advanced economies, it left its estimates alone for emerging markets. It's calling for economic growth to accelerate slightly this year to 4.1 percent and then to pick up again next year to 4.6 percent.

At the same time, bonds from emerging markets are offering higher yields than U.S. Treasurys, which are close to record lows, and bonds from Europe and Japan, which can have yields of less than zero.

— Lower-for-longer rates

Expectations are rising that the Federal Reserve will raise interest rates only slowly. A jump in rates would not only drag down the value of emerging-market currencies, it would also likely result in less foreign investment in emerging markets. The dollar has slowed its ascent this year.

Of course, risks remain for anyone considering investing in emerging markets. Investors are always cautious about political stability in countries like Russia. China is still facing a challenging slowdown in its economic growth. And a quick round of rate hikes by the Federal Reserve could unravel things.

But many fund managers say they expect interest to continue despite the risks.

"Two things have been very scarce in the world: income and growth," says Richard Turnill, global chief investment strategist for BlackRock. "And emerging markets are an area that potentially offers both."

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