Emerging market (EM) ETF investing is currently in a tight spot. The dollar strength, rising rates in the United States, capital outflows, a slump in China’s economy, strong inflation and a debacle in Russia investing have all added up to the EM crisis.

The Fed started steep rate hikes this year, which actually caused recessionary fears. The S&P 500 is off 10.5% past month (as of Oct 10, 2022). The U.S. dollar has been strong this year with the greenback ETF (UUP Quick QuoteUUP - Free Report) adding 4.2% past month (as of Oct 10, 2022). The U.S. dollar index rose to fresh two-decade highs and most emerging economies’ currencies have been falling to multi-year lows against the greenback.

Still, iShares MSCI Emerging Markets ETF (EEM Quick QuoteEEM - Free Report) has been off 9%, beating the S&P 500 past month. iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB Quick QuoteEMB - Free Report) has lost 8.3% during the same time-frame, again beating the S&P 500.

Benchmark gauges of emerging-market bonds, in both dollars and local currencies, have been rallying in October after posting declines in eight of the nine months this year. The equity benchmark recovered last week from the worst monthly decline since March 2020, while the currency index rebounded the longest streak of losses since 2019.

Why Emerging Markets Are Good Bets

Undervaluation

First, EMs have suffered a lot amid the pandemic. VWO has a P/E of 7.00X while SPY has a P/E of 21.70X. Hence, in the global relief rally (if there is any), emerging markets have better potential to grow. Morgan Stanley’s chief Asia and emerging market equity strategist, Jonathan Garner said in CNBC’s “Squawk Box Asia,” that “we’re at very distressed valuations, very oversold” in the emerging markets equities space before adding that “there are some signs already of healing in the leading edge of EM, i.e. in Korea and Taiwan,” as quoted on ETF Trends. Lately, Garner wrote that EM stocks are close to bottoming out and thus upgraded EM stocks to overweight from equal weight.

Falling Inflation in EMs As Opposed to Developed Economies

Developing nations from India to Brazil are reporting declines in consumer-price growth. India has reported four consecutive months of declines in its consumer price index, while Brazil and South Africa have also joined the peak-inflation group. This has lessened the need for rate hikes in some of the biggest EM economies.

Bets for Terminal Rates in Developed Economies Falling

From the United States to United Kingdom and Europe, bets on rate hikes that kept surging until last month are now falling, per Bloomberg. Money markets are trimming their bets for terminal rates in developed markets. They now call for a top rate of 5.8% in the UK, 3.15% for the European Central Bank and as low as 4.5% for the Fed, all declining from peaks reached in September, per Bloomberg article.

High Interest Rates in EMs Than Developed Nations

Yields are higher in emerging economies. iShares Emerging Markets Dividend ETF (DVYE Quick QuoteDVYE - Free Report) yields as much as 6.83% annually. Global X MSCI SuperDividend Emerging Markets ETF (SDEM Quick QuoteSDEM - Free Report) yields 6.80% annually. These funds are off 7% past month.

And if investors turn to bonds, gains should be even stellar. Invesco Emerging Markets Sovereign Debt ETF (PCY Quick QuotePCY - Free Report) yields about 4.70% annually and is off 6.4% past month. Chances of disinflation also favor a bond rally in the EM segment. A Bloomberg article in 2021 pointed out that the projected inflation for a cross-section of developing nations will average 4.74% from 2026 to 2031 versus an average of 5.25% over the past five years, if we go by an analysis.

“The disinflationary outlook offers a potential capital gain and a stable high income from emerging-market debt,” according to Akira Takei, a global fixed-income money manager in Tokyo at Asset Management One Co., which manages the equivalent of about $510 billion, as quoted on a Bloomberg article published in Feb 2021.