Emerging market stocks are experiencing something of a comeback.
The Vanguard Emerging Markets Stock Index fund gained 6% in the four weeks ended Feb 17, and another 9% a month later. In fact, March turned out to be the best month for emerging market equities since January 2012, just after they slipped into a bear market.
So what's going on? Several factors are at play:
* The Federal Reserve hasn't raised rates aggressively. Heading into the year, the Fed was expected to bump up short-term borrowing costs four times in 2016. But thanks to sluggish growth, Wall Street now anticipates only two hikes this year — if that. The upshot is that investors crave more yield. Plus, low rates fuel risk-taking and speculation among investors. And both forces are driving investors to the emerging markets.
* The U.S. dollar has been weakening. The greenback has fallen dramatically against the Brazilian real, Russian ruble and South African rand over the past three months. In fact, the dollar has declined significantly against pretty much every emerging market currency with the exception of the Argentine peso.
Why does this matter? A decent amount of debt held by developing nations is dominated in U.S. dollars. So when the dollar strengthens, the real cost of servicing that debt increases, putting pressure on these economies. Conversely, a weak dollar provides debt relief to these nations, improving their economies.
* Oil prices have rebounded. Since Jan. 20, the price of a barrel of crude oil has jumped 39%. This is an especially important boon for energy producing countries such as Brazil and Russia that have suffered through a 76% decline in oil in the prior four years.
So, is it time to dive back into these stocks, which dominated the stock market from 2000 to 2010?
The good news is that prices are still cheap, and valuations are a big reason to consider this asset class. The price/earnings ratio for emerging market stocks, based on projected profits, is 12.1. That compares quite favorably to the 16.3 P/E ratio for the global markets.
Of course, low valuations can also signal problems with a group of stocks. And with the emerging markets, investors have plenty of reasons to be cautious.
Let's take oil. While prices have risen recently, headwinds remain.
Oil is subject to the laws of supply and demand, and supply isn't likely to fall dramatically despite tepid global growth. Iran is likely to increase production after its nuclear arms deal with the United States, notes S&P Global Market Intelligence's Stewart Glickman, while Russia continues to export a good deal of oil and natural gas.
Toss in the "low probability" that major oil producers will come to some sort of agreement to stymie production, and it's unlikely that oil prices will jump back to $100 a barrel anytime soon.
- Calculator: What is my risk tolerance?
Low commodity prices feed into the dire straits in which many emerging markets currently reside.
If you currently own an emerging market mutual or exchange-traded fund, hold on: you are investing for the long-term.
And if you have several decades to go before needing to cash in, there's an argument to be made for taking a flier on the emerging markets with a small part of your portfolio.
But for money that you'll need to tap in a few years, think twice.