Koesterich Sees Value in Emerging Markets

Due to slowed economic growth, emerging markets equities and some of the largest ETFs tracking those stocks, have lagged U.S. stocks this year. Year-to-date, the SPDR S&P 500 (NYSE:SPY) has outpaced both the Vanguard MSCI Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSE:EEM) by about 500 basis points. VWO and EEM are the two largest emerging markets ETFs by assets.

The developed world outlook is not much better with U.S. GDP forecast grow by two percent next, assuming the infamous fiscal cliff is dodged. Outside of Germany and perhaps France, growth will likely continue contracting in the eurozone and Japanese economic output is expected to be anemic. As such iShares Global Chief Investment Strategist Russ Koesterich recommends investors overweight emerging markets.

"The story in emerging markets looks more encouraging," Koesterich wrote in a blog post. "While nobody expects China or India to return to their glory days of 10% or more annual growth, things may pick up next year. Growth in China could accelerate from 7.8% this year to 8.2% in 2013. Expectations are even stronger for Brazil, where the economy is expected to grow by 4%, versus a lackluster 1.5% in 2012."

China reported third-quarter GDP growth of 7.4 percent on Tuesday night, matching analysts' estimates. That is down from 7.6 percent a year earlier, but the number is viewed as encouraging by some that have been yearning for a bottom in Chinese stocks.

Chinese stocks have taken on a value feel. The iShares FTSE China 25 Index Fund (NYSE:FXI), the largest China ETF, sports a price-to-earnings ratio of 12.5 and a price-to-book ratio of 1.55, indicating the fund is cheaper than EEM, at least by those metrics.

Koesterich notes that one reason for optimism with emerging markets is aggressive monetary easing.

"In Brazil, short-term rates have fallen from over 12% to an all-time low of 7.25%. Typically, monetary policy works with about a six- to 12-month lag. Just as tighter monetary policy in 2011 was a drag on growth in 2012, this year's easing should be supportive of growth in 2013," wrote Koesterich.

Amid slowing growth and increasing concerns that Brazil's government has grown hostile toward foreign investors, the iShares MSCI Brazil Index Fund (NYSE:EWZ) is off almost four percent this year. That makes the ETF by far the worst offender of the major funds tracking BRIC nations.

EWZ trades at almost 18 times earnings, which may seem pricy, but it that puts the fund below the comparable Chile and Mexico ETFs on the valuation scale.

"Despite the fact that emerging markets are set to significantly outpace developed markets, the valuation of stocks remains low in emerging markets compared to those in developed markets," wrote Koesterich. "Emerging market countries are still trading at around a 20% discount to developed markets. In particular, we continue to like China, Brazil, Indonesia, and Russia."

The iShares MSCI Indonesia Investable Market Index Fund (NYSE:EIDO) and the Market Vectors Indonesia ETF (NYSE:IDX), but the two funds have surged in the past three months, posting an average gain above five percent.

For more on emerging markets ETFs, click here.