Emerging-market stocks – particularly in Asia – are still heavily undervalued despite a strong first-half rally, say investment experts at Pictet Asset Management and Societe Generale.

After a bad 2015 – in which the MSCI EM index fell 14.9% – EM stocks have rebounded, returning 11.2% last year and another 18.4% in the year to June 30.

Pictet AM was particularly bullish on Asian equities in its five-year investment outlook last week, tipping them for an annual average return of 11.7% over the next five years.

The Swiss firm said they would perform better than any other regional sub-group, well ahead of the euro area (7.6%), the UK (7.6%), Latin America (6.9%), Japan (6.8%), the US (1.9%) and the global average (4.6%).

Overvalued assets

Luca Paolini, London-based chief strategist at Pictet AM, said the most overvalued assets were US equities, European bonds (courtesy of quantitative easing and “a triple dip recession”) and the dollar (thanks to “policy divergence”). The most undervalued, he noted, are EM local-currency assets, Japanese equities and telecoms stocks.

Alain Bokobza, Paris-based head of global asset allocation at Societe Generale, pointed to various spurs for emerging markets, including the recovery in commodity prices and improving prospects for global growth.

But he is not positive on EM stocks across the board. SocGen is overweight Russian and South Korean equities, but is selling positions in Chinese equities, where it fears the impact of regulatory changes.

“[In China], the impact of liquidity and regulatory tightening will likely be negative to real growth momentum down the road – while nominal growth has started to slow,” said Bokobza. “What's uncertain is how large the damage will be.”

Still, despite this year's EM equity gains, he believes there is still plenty of upside. “We believe EM equity valuations remain cheap relative to DM equities,” said Bokobza. By relative price-to-book ratios, EM stocks are 32% cheaper than their DM counterparts, he added.

But what about concerns that rising US interest rates will boost dollar strength? Historically, there has been a strong inverse correlation between dollar strength and the performance of EM equities, relative to DM equities.

In fact, said Paolini, over the next five years the dollar is very likely to lose value against the currencies of its trading partners.

Bokobza agreed: “Given firming EM economic growth and less upward pressure on the USD, we see room for further EM equity outperformance,” he said.

Asian bonds

Meanwhile, both Pictet AM and SG agreed the outlook for Asian bonds was bright.

Pictet AM predicted that average yields for 10-year local-currency government bonds, five years from now, would be 5.8%. That is slightly below the EM average of 7.2%, but well above predictions for the euro area (2.4%), the US (3.3%), Japan (2.1%) and the global average (2.7%). The prospects for DM bonds are “very poor” over the next five years, noted Paolini.

He also pointed to falling inflation and structural reforms across emerging markets. Changes have been particularly noteworthy in China, Brazil, Indonesia and Argentina, said Paolini. “Five years ago there was a degree of complacency; now [governments] know what the problems are and are addressing them.”

This will be heartening news for investors in the region on the 20th anniversary of the start of the Asian financial crisis.