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By Jason Stipp and Patricia Oey | 12-06-2013 03:00 PM

Emerging Markets Not Really a Bargain

Lower valuations reflect a slower growth environment, with currency volatility continuing to affect certain markets in the near term, says Morningstar's Patty Oey.

Securities mentioned in this video
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Jason Stipp: I am Jason Stipp for Morningstar. After a disappointing 2013, emerging-markets investors may wonder what's next, what's coming up in 2014, and will the volatility continue? Here to offer her insights is senior fund analyst Patty Oey who covers emerging-markets funds.

Thanks for joining me, Patty.

Patty Oey: Thank you for having me.

Stipp: A lot of investors are looking at the MSCI Emerging Markets Index, and they're thinking maybe it looks cheap now. We've had a very disappointing year, especially compared with developed markets. What's your take on that assessment of emerging-markets valuations?

Oey: I would caution against saying, overall, emerging markets are cheap, mainly for three reasons. The first reason is that in the MSCI index about 20% of the index is in China, and within China about 40% of that is in its large banks. The large banks are trading at extremely cheap valuations, and this is because there is a lot of concern about the quality of their loan books. As China implements some of these reforms there is a lot of uncertainty regarding the regulatory environment as well as the competitive environment. These banks are actually trading at record price/book and P/E multiple lows. So, there could be some value in these names, but it is going to be a very turbulent ride in the near and medium term.

Stipp: You mentioned that emerging markets, in general, are in some ways facing their own kind of new normal, something that U.S. investors have heard a lot about over the last few years, since the financial crisis. What do you mean when you say that they have their own new normal?

Oey: On some level, people are saying that emerging-markets [sector] looks cheap because it looks cheap on a P/E basis relative to its recent history. But in the past, we had two very big distortions, namely a big commodity boom and incredibly low interest rates. This new normal, we head in the opposite direction of what we had over the last decade. So, the commodity boom is over, interest rates are rising, and we are going to see less of a credit-fueled growth compared with in the past.

Stipp: In summary, would you say that investors that are hoping for the levels of growth they've seen in emerging markets might want to reset their expectations a little bit for what may come ahead?

Oey: Yes, definitely. For what it is worth Jeremy Grantham and his colleagues at GMO forecast about a 3% annual real return over the medium term. That just gives some perspective.

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