An improved return outlook and slowed, and U.S. rates are rising faster. Higher consistent diversification benefits interest rates in the U.S. relative to emerging from emerging markets markets raise fair value because they lead Within international markets, our fair-value the dollar to trade at a forward discount to framework shown in Figure II-15 suggests that emerging-market currencies, which (according emerging markets are attractively valued for the to uncovered interest rate parity) should raise 15 expected returns for a U.S.-based investor. first time since the pandemic. Steep sell-offs in 2021 and 2022 stemming from elevated inflation, Our outlook suggests that emerging markets aggressive policy tightening, slowing growth, should return between 7% and 9% (2.3 percentage and political risks have increased the emerging- points higher than U.S. equities) over the next market risk premium. Although near-term risks decade. Further, emerging-market equities still in the form of a strong dollar, global recession, have a lower correlation with U.S. equities than and geopolitical tensions remain, the narrative developed ex-U.S. markets and a higher inflation appears oversold. Faster policy normalization in 16 emerging markets than in the U.S. and slowing beta to U.S. inflation. For these reasons, we economic conditions were the main drivers believe that a balanced allocation to emerging- behind the decline in our fair-value estimate market equities plays an important role in from September 2021 to June 2022. Rate hikes investors’ portfolios. in emerging markets, however, have broadly FIGURE II-15 Emerging-market valuations are attractive  o i t a  r E / s P t e k r a Fair-value range g m n i MSCI Emerging Markets g r P/E rati atual e  m E MSCI Emerging Markets  P/E rati re ite               Notes: The statistical model specification is a five-variable Ordinary Least Squares regression that uses the following variables: inflation for six major emerging markets countries (Brazil, China, India, South Korea, Mexico, and Taiwan) weighted by MSCI monthly index weights; monthly average of daily real 2-year U.S. Treasury yield; emerging markets central bank policy rates weighted by GDP in U.S. dollars, minus the federal funds rate; Vanguard’s leading economic indicators (VLEI) for China, Brazil, and Mexico (weighted average based on country GDP in U.S. dollars); and monthly average of daily U.S. equity market volatility, as measured by the CBOE Volatility Index (VIX). P/E3 is the price divided by trailing 3-year average earnings. Sources: Vanguard calculations, based on data from the Federal Reserve Bank of St. Louis FRED database and Bloomberg, as of September 30, 2022. 15 See Davis et al. (2021) for more details on our fair-value model. 16 The predicted median correlations for emerging-market equities are 0.70 with U.S. equities and 0.74 with developed ex-U.S. equities. The inflation beta—the linear regression coefficient between the 30-year U.S. inflation forecast and the 30-year asset return forecast—is 0.71 for emerging markets versus –0.44 for developed-market ex-U.S. equities. 53