With the MSCI Emerging Markets Index’s dip into negative territory last year, and slowing economic growth in the big nations that dominate the index, many investors have been shunning the asset class. That response can only be described as shortsighted. Not only does it disregard the longer-term direction of the global economy, it also overlooks a near-term opportunity to gain emerging market (EM) exposure at historically low valuations.

That the global economy has shifted fundamentally is undeniable. Twenty-five years ago, EMs represented 1 percent of the global economy; now they account for one-third or more, depending on which economic yardstick you use. Does anyone believe EMs won’t represent an even greater share of global economic activity 10 or 20 years from now? EM nations are forecast to continue growing their economies, and their long-term corporate earnings, at a significantly more rapid pace than developed countries.

How Much To Allocate To Emerging Markets?
I would guess that, despite these trends, most U.S. investors at present are substantially underweight EMs or have no exposure at all. They may be underestimating EMs’ growing economic importance, partly because of shifting measures. Traditionally, investors have relied on equity market capitalization to calculate a nation’s economic share. That method pegs EMs’ market share at 18 percent, or nearly 26 percent, if you eliminate the “free float” adjustment that subtracts government-held and other shares not available to the public.  

However, the growth of EM stock markets tends to lag their economic expansion. This suggests that share of global gross domestic product (GDP) is a better indicator of EM nations’ growing economic muscle, and perhaps a better way to think about EM allocations. At the end of 2012, EM countries accounted for nearly 32 percent of global nominal GDP in current U.S. dollars, outstripping the U.S. economy’s 22 percent share. When nominal GDP is adjusted for purchasing power parity, the EM share rises to 43 percent of the global economy while the U.S. share drops to 19 percent. 

Given this new global economic reality, advisors can make the case for EM portfolio allocations of anywhere from 18 percent to 43 percent. While valuations can shift rapidly at times, lately they have been in the range that our investment team considers compelling, even when looking at index valuations alone. As of the end of February 2014, the MSCI Emerging Markets Index had a price-earnings ratio of 11.2, as compared with 18.7 for the MSCI USA Index and 20.8 for the MSCI Europe Index. EMs look equally attractive in terms of metrics such as dividend yield and price-to-book ratio.

Because EM equity prices and GDP trends will likely converge over time, it’s also worth looking at their ratio of market capitalization to GDP. At the end of 2013, EMs had a market-cap-to-GDP ratio of 0.37 while the U.S. ratio was 1.14.  This tells us that EM equity markets have a long way to go before they fully reflect the economic power of emerging nations -- and that investors may be able to benefit from this convergence in the meantime.

Addressing Emerging Market Concerns
For investors who worry that EMs’ 2013 downturn may signal some impending crisis, like the Asian financial crisis of 1997-98, I would point out that market conditions are quite different today. Back then, EM currencies and debt were pegged to the U.S. dollar, so their debt-service costs soared as the U.S. dollar rallied. As a result, many EM countries stopped directly pegging their currencies to the U.S. dollar, giving them more flexibility to manage currencies and interest rates, and have adopted policies that let them issue debt in either the U.S. dollar or the local currency. Beyond that, EM nations are generally in much better fiscal shape than they were in the 1990s; in fact, many have higher reserve levels and lower debt than the G7 nations.

If investors have reacted fearfully to negative news about EMs, it could be out of concern that their underperformance is due to slowing economic growth and may become chronic. Much has been made of the slowdown in China’s economic growth, in particular. It’s true that China’s 7.5 percent growth target for this year, and its expected annual growth rate of 7.7 percent over the next decade, fall short of its 10 percent average annual growth over the past 30 years. While that’s still a healthy rate of growth, some slowdown in growth of the large BRIC nations (Brazil, Russia, India and China) should be expected as their economies mature.

However, several other factors have contributed to the recent deceleration of EM economies, including policy missteps. For example, Brazil’s president, Dilma Rousseff, reversed many of the economically advantageous policies that were previously in place, putting a damper on foreign and domestic investment alike. Also having some short-term impact are the declining currency values some EMs have experienced. Countries that import our goods and have a current account deficit, such as South Africa, Turkey and Chile, are in effect short the U.S. dollar. With weaker currencies and slower growth, their corporate earnings have also taken a hit. Nevertheless, the growth outlook and strong fundamental characteristics in many EM markets remain compelling, and as the larger EM economies stabilize, some of the smaller EM nations will likely follow.   

Choosing An Active Approach
Although long-term EM growth prospects are strong, some caveats are in order. EMs have tended to be volatile in the past, and investors should be prepared for that volatility to continue or even increase. Thus, steps to mitigate risk by diversifying or hedging exposure are vital. This is one of the key reasons to consider an active investment approach that can be discriminating in pursuing EM opportunities while also bringing risk management skills to bear. Generally, those emerging markets investors who can look beyond a simple indexing approach may find opportunities in certain countries, industry sectors or companies that are very attractive.

Most important, these considerations shouldn’t obscure what may be a historic opportunity to invest in the world’s fastest-growing economies. The widespread reaction to a spell of bad news about EMs could prove to be very good news for far-sighted investors.

Nathan Rowader, a registered representative of ALPS Distributors Inc., has been with Forward since September 2008 as director of investments. Investment objectives, risks, charges and expenses of the Forward Funds should be carefully considered before investing. A prospectus with this and other information may be obtained by calling (800) 999-6809 or by downloading one from www.forwardinvesting.com. It should be read carefully before investing.