Month: July 2023

A Tale of Two Decades for Emerging Markets and the S&P 500 (Part 1)

 

Emerging market stocks have persistently underperformed the S&P 500 for the past decade, leading to renewed faith in American exceptionalism and consistent international flows into the perceived soundness and reliability of U.S. assets. Nevertheless, if we look at the data, we can conclude that there are good reasons for the run in U.S. stocks but also evidence to believe it will not last for ever.

The performance of EM stocks relative to the S&P 500 can be seen as a tale of two decades. As the chart below shows, EM stocks dominated for the first ten years while the S&P 500 won handily in the second decade, through June 2023.

Most of this performance can be explained by  changes in valuation as measured by price-earnings and CAPE ratios (CAPE, cyclically adjusted PE), as shown below.  U.S. ratios started high in 2002 and fell during the next decade and then rebounded in the 2012-2023 period. The exact opposite occurred for EM:  ratios were at very low levels in 2012, rose during the decade and now have fallen back to low levels.

The chart below digs deeper to further explain the disparate performances of EM and S&P 500 stocks over the past two decades, by showing annualized earnings growth and currency effects for both assets. The chart breaks down annualized index performance for both decades in terms of earnings and PE multiple expansion, and also provides the contribution from currency exchange  rate movements for emerging markets. The S&P suffered from significant multiple contraction in the first decade and benefited from a large multiple expansion in the second decade. EM benefitted from strong earnings growth boosted by currency appreciation in the first decade and suffered from negative earnings growth pushed down by  currency depreciation in the second decade. CAPE ratio for the S&P 500 fell slightly between 2002 and  2012 and then expanded massively in the second decade, while CAPE ratios for EM rose sharply between 2002 and 2012 and then collapsed from 2012 to 2023.

The drivers of S&P relative performance over the past decade have been primarily multiple expansion and dollar appreciations, two factors that have proven to be cyclical in the past and highly prone to reversion.

We can also point to other extraordinary events that have provided a one- time boost to the S&P 500 index.   Recent work from Michael Smolyansky at the Federal Reserve ((link) and Minje Kwun at Verdad Capital (link)  highlight the importance that reductions in corporate taxes and low interest rates have had in driving earnings growth over the past decade. The chart below shows the remarkably favorable circumstances that American corporations have had since the late 1980s, and the sharp fall in interest rates and taxes over the 2012-2022 period. The recent rise in interest rates and the prospect of rising U.S. debt and fiscal deficits point to a cyclical reversion of these trends in the coming decade.

None of the factors boosting U.S. stocks have benefitted emerging market stocks over the past ten years, which may leave EM stocks better positioned to outperform.

2Q 2023 Expected Returns for Emerging Markets

Emerging market stocks once again are lagging U.S. stocks in 2023, as they have consistently over the past decade, rising by 3.5% during the first semester compared to 16.8% for the U.S. market. The strength of U.S. stocks can be attributed to the resilient American economy and a return of speculative fervor for tech stocks, this time driven by the sudden discovery of the transformative power of “Artificial Intelligence.” Nevertheless, below the surface conditions are also positive for emerging market stocks. Almost all the underperformance of EM stocks can be attributed to China, while most other markets are not doing badly at all. Moreover, EM stocks are now very cheap compared to the U.S. market and value is being rewarded. Also, the U.S. dollar has been on a significant downtrend which, if sustained, will provide a significant tailwind for international assets, including emerging market stocks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE) is based on the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful tool for highly cyclical assets like EM stocks.   This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University. We use dollarized data to capture currency trends. Seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period.  Earnings are adjusted according to each country’s current place in the business cycle and then assumed to grow in line with nominal GDP projections taken from the IMF’s World Economic Outlook.

As expected, “cheap” countries (CAPE ratios below their historical average) tend to have higher expected returns than “expensive” ones (CAPE ratios above the historical average). These expected returns make two huge assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

The second assumption is well supported by historical data if seven-to-ten-year periods are considered, but not over the short term (one to three years).

However, when during certain periods “cheap” markets on a CAPE basis are enjoying short-term outperformance investors should take note, as the combination of value and momentum can be compelling. As the chart below shows, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” would have provided very high returns, even considering negative returns from Colombia. The chart shows Expected Return rankings from one year ago and, in the last column to the right, the total returns over the past year.

That cheap markets are now performing well is very encouraging for EM investors.  To cheap valuations, momentum, and a weakening U.S. dollar we can add the improvement in global business conditions. Almost all EM countries are now in the upswing of the business cycle, a time when they tend to outperform significantly. Moreover, the global economy is also recovering, and the U.S. is expected to achieve a soft landing later this year. This synchronized global recovery should be supportive of cyclical assets like commodities, value stocks and emerging markets.