CAPE – The Emerging Markets Investor

A Tales of Two Decades for Emerging Markets and the S&P 500 (Part 2)

Emerging market stocks have suffered a decade of dismal returns while American stocks have soared. In a previous post (link), this divergence was explained by valuations (high in EM and low in the U.S. in 2012) and the appreciation of the U.S. dollar over the past ten years. In addition, U.S. corporations have benefited from historically low interest rates and tax cuts. All of the factors that benefitted U.S. stocks are likely to eventually revert, which would lead to a new period of outperformance for international assets. In this post, we look at this matter in further detail.

The chart below shows the twenty-year performance of the primary emerging market country MSCI indices, as well as the MSCI EM index and the S&P 500. During the 2002-2012 decade, the S&P500 underperformed the MSCI EM Index as well as every major country in the index. The opposite occurred from 2012-June 2023, as the S&P500 soarer while EM languished. Only tech-heavy Taiwan and India managed positive returns over this period.

Two Decades of Index Returns for Emerging Markets and the S&P500

In the chart below, this divergence of returns is explained in detail by changes in valuation parameters (CAPE ratios, cyclically adjusted price earnings) and dollar-denominated earnings growth. There are two primary conclusion from this analysis. First, CAPE ratios have gone full circle. S&P500 CAPE ratios started high in 2002, edged down through 2012 and then soared back to very high levels over the past decade. Global EM CAPE ratios started low, went up to high levels in 2012 and then went right back to where they started. As for earnings, for the S&P500, coming out of recession in 2002, earnings growth for the first decade was high and then moderate for the second decade (propped up by low interest rates and tax cuts). EM earnings were very high for the first decade and flat to negative for the second decade, with the exception of tech-heavy Taiwan. (Argentina should be taken with a grain of salt, as numbers are distorted by exchange controls)

The last column to the right in the chart above shows expected returns for the next seven years. The three countries with the highest expected return -Colombia, Chile and Turkey – have returned to the valuation levels they had in 2002 after reaching very high levels in both 2007 and 2012. Brazil’s CAPE ration went from 5.1 in 2002 to 12.9 in 2012 (after peaking at 32.1 in 2007!) and is now at 9.7. Similar to Brazil, the Philippines and Peru now have CAPE ratios well below 2012 but not nearly as low as in 2002. The two most expensive markets – the S&P500 and India – have CAPE ratios well above 2005 and 2012, both at near record levels.

Earnings growth in dollars for most EM countries was extraordinarily good between 2002 and 2012 and dismal in the 2012-June 2023 period, even considering the big surge in earnings in 2022 experienced by commodity producers (Chile and Brazil.) Poor earnings growth is explained by a strong dollar, low commodity prices and intense competition for manufacturing nations in a depressionary global environment. Surprisingly, despite an appreciating currency and a significant tech sector, China had negative 0.7% annualized earnings growth during this period.

The expected returns displayed in the chart above assume that earnings will grow in line with nominal GDP growth for all countries. This also assumes that the currencies will be stable relative to the dollar. Given the current direction of China and its large weight in the MSCI Index, this may be an overly optimistic assumption which exaggerates potential returns for global emerging markets.

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.

Mexico’s Bull Run

Despite the antics, the atavistic fondness for state intervention and control, and the frequent attacks on both local and foreign business interests, Mexico’s populist leader Andres Manuel Lopes Obrador (AMLO) is presiding over the country’s best financial markets in years.

AMLO can be credited for a sound fiscal policy and for letting the orthodox Central Bank do its job. This hasn’t resulted in better economic growth but it has allowed for a more stable economy than most of Mexico’s peers around emerging markets. However, the main cause for market enthusiasm seems to be the hope that Mexico will be a major beneficiary of “friend-shoring” investments, as global manufacturers look for ways to diversify away from China.

The performance of Mexican assets has been remarkable. As shown below, the Mexican peso is the strongest currency in the world for the past one and three years, periods marked by considerable chaos in currency markets in many other emerging markets

The Mexican stock market also has done exceptionally well, as shown in the chart below. The Bolsa is a top performer for both the past one and three years. For the past five years it is near the top, surpassed mainly by tech-heavy markets (U.S., Taiwan, Netherlands, Denmark). This is impressive given that Mexico does not have a tech sector.

The current sectorial composition of the Mexican market relative to other markets is shown below. A characteristic of the Mexican market is the high weight of defensive stocks, mainly consumer oriented telecom, food and retailing businesses. Unlike in most other emerging markets, the Bolsa is not dominated by state companies or mature cyclicals, but rather by well managed private concerns. The combination of a stable economy and well-managed private companies is a rarity in emerging markets.

The ten largest stocks in the MSCI Mexico index are listed below. With the possible exceptions of Banorte and Cemex, these are profitable world class companies with dominant market positions, all trading at near all-time high stock prices.

After this impressive bull run, what are the prospects for the Mexican market?

It should be noted that both the currency and stock prices started this run at low levels in both relative and absolute terms. As the chart below shows, Mexico’s Real Effective Exchange Rate was at historically low levels in 2019, and it remains competitive today. Over the past 20 years the peso has been managed like an Asian currency, for stability and export competitiveness. The Brazilian REER, shown for contrast, is much more volatile, which causes havoc for managing the current account and promoting manufacturing exports.

The next chart shows that the cyclically-adjusted price earnings ratio (CAPE) for Mexico was at historically low levels in 2019, and the PE ratio was well below trend. The CAPE ratio has now normalized but is still far from stretched.

Mexico’s CAPE ratio based on expected earnings for 2023 is currently at 17.2 which is in line with the country’s average for the past three decades. As shown below, based on historical returns, prospects for future seven- and ten-year returns are moderately positive.

Bull runs are not usually stopped by valuation concerns. Along with India, Mexico may continue to be one of the few large emerging market with a credible narrative and the capacity to absorb foreign capital. Nevertheless, in coming years, investors will need to see “Friend-shoring” capital flows go from hope to reality to sustain the Mexico story.

Brazil’s Grievous Manufacturing Collapse

Brazil has become a posterchild for the Middle-Income Trap which hinders countries no longer able to compete against low-wage countries but without the productivity growth to compete in the higher value added industries dominated by advanced economies. But little attention has been given to the related economic phenomenon which strikes commodity producers – “Dutch Disease,” also known as the Natural Resource Curse. The combination of the two for Brazil has caused crippling premature deindustrialization.

Brazil has suffered two severe bouts of “Dutch Disease.” The first during the commodity boom of the 1970s which was followed by the bust of the 1980s and a “lost decade” of economic stagnation. The second, during the 2001-2012 commodity super-cycle driven by China’s “economic miracle, which was also followed by a long economic depression. These two commodity booms were marked by similar excesses — overvalued currencies, unsustainable consumer booms, excess fiscal spending and high levels of debt accumulation, a deterioration of governance and a rise in corruption. In their wakes, the booms left behind a debilitated manufacturing sector, high debt levels and lower growth prospects.

Brazil’s “Dutch Disease” has been worsened by the concurrent strong growth of the farming, mining and oil sectors — all productive and capital intensive activities with a high degree of export competitiveness. The rapid growth of these sectors, and the discovery of the giant offshore pre-salt oil fields, has strengthened the current account and caused a structural appreciation of the Brazilian real. The loss of competitiveness of Brazil’s manufacturing sector has been more than compensated by the increased production and dollar revenues of the growth sectors. Unfortunately, these successful sectors generate scarce jobs and lack the significant multiplier effects of the manufacturing sector.

The chart below shows manufacturing GDP as a percentage of GDP for both resource rich and resource poor countries in emerging markets. The declining trend for commodity exporters relative to commodity importers is notable, and Brazil stands out in particular.

In 1980, at the end of the 1970s commodity boom, Brazil was the dominant manufacturing power in emerging markets (China surpassed Brazil’s production levels but was behind in terms of complexity and quality of manufacturing). The following chart from the World Bank shows manufacturing value added for the primary emerging markets (and France for comparative purposes) both for 1980 and 2021. The rise of China and the relative decline of Brazil are striking.

The same data is shown below with Brazil as the benchmark, to measure relative performance. Over this period, China’s manufacturing value added went from two times Brazil’s to 31.3x, a relative increase of 15.7x. India went from 44% of Brazil’s level to 2.9x. Every single country in the chart has gained relative to Brazil. This includes commodity producers (highlighted in red) which also may have suffered Dutch Disease. Most striking are Indonesia and Malaysia which went from 15% of Brazil to 150%, and 8% to 56%, respectively, a testament to the Asian commitment to currency stability and manufacturing exports.

Finally, the following chart shows the decline in industrial employment in Brazil over the past decade. In 2019, according to World Bank data, only 20% of employment in Brazil was in industry, a decline from 23.4% in 1991. This places Brazil at a level similar to advanced rich countries with service-intensive economies. In Brazil these service jobs tend to be poorly paid and unproductive with very few opportunities for training and advancement.

Brazil’s manufacturing collapse has no easy solution. Brazil’s successful commodity exporters yield extensive political power, not the least with the oversized financial sector. Schemes like those adopted by Argentina, featuring multi-tiered currencies and taxes on exporters are difficult to implement and have high costs. A return to high tariffs on imports would be highly unpopular. A mix of these policies is likely to be introduced by the new administration with elevated short-term costs and unclear long=term benefits.

Emerging Markets’ no Growth Decade

Emerging market stocks have performed poorly for more than a decade both in relative and absolute terms. This can be explained by a marked decline in price to earnings multiples since the very high levels achieved in 2008 and 2012 combined with poor growth in these earnings. In turn, low growth in earnings were caused by a significant deterioration in the GDP growth of most emerging markets.

We show the evolution of multiples and earnings in the following charts. CAPE multiples are at a third of the level reached in 2008 while earnings have been flat in nominal USD terms.

This remarkable result can be explained by the unbalanced growth of the global economy. While emerging markets are said to be growing GDP at a higher rate than developed markets, the growth is highly concentrated in China (and to a degree India). Emerging markets ex China and India have languished over this period. We show this in the chart below.

Given the disappointing growth of emerging markets ex China since the GFC, it is not surprising that earnings growth has been poor. What is stunning is the lack of earnings growth in both China and India, despite their high GDP growth, as shown below.

The explanation lies in the unbalanced nature of Chinese growth, which relies on the repression of the consumer to subsidize the export sector and unproductive state investments in infrastructure and industry. China’s excess capacity is increasingly dumped on emerging markets, leading to deindustrialization, low productivity and low growth.

Using CAPE Ratios in Emerging Markets

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side. The Cyclically Adjusted Price Earnings multiple (CAPE) has proven effective in highlighting them.

The CAPE takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

CAPE is best used as a long-term allocation tool. However, it is not effective as a timing tool. Market timers seeking short-term returns will be more successful using traditional technical analysis to identify trends and paying close attention to investor sentiment and liquidity flows.

CAPE works particularly well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia); it works less well for more stable economies (e.g., East Asia).

In recent years CAPE has has been ineffective in predicting forward annual returns. This has occurred because momentum has been more important in determining stock performance than valuation indicators. Moreover, emerging markets started the past decade at very high valuations, and only recently have come to trade at cheap levels and, in some cases, extremely low valuations.

Since October 2020, we have seen a marked change in the investment environment, with the value factor in both U.S. and international stocks starting to outperform “growth” stocks. Emerging market value stocks have outperformed the EM index by over 20% during 2021-2022. Also, by and large, “cheap” CAPE stocks have started to reward investors. The cheapest stocks on a CAPE basis at the end of 2021 (Turkey, Chile and Brazil) all performed exceptionally well in 2022.

In the charts below we see what CAPE ratios are currently telling us about future returns based on historical precedents. We map index returns and CAPE ratios for the U.S., GEM (Global Emerging Markets) and the most important emerging market countries (China, India, Taiwan, Korea and Brazil) and also for several countries of interest (Turkey, Philippines and Mexico). The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country specific data is more significant because the CAPE ratios capture better the evolution of the single asset.

S&P 500 : The market has not provided 10-year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2022 was at 27.3, a level which suggests moderate nominal returns in the low single digits for the next 7-10 years.

Global Emerging Markets. At the current level (15.4) the GEM CAPE provides little insight. The probability of negative or high returns both appear to be low. GEM should be bought below 15 and sold above 20.

3. China’s short and turbulent stock market history provides few data points for CAPE analysis. Nevertheless, the current CAPE (9.5) has provided high returns in the past and points to low risk of negative returns. Chinese stocks should be bought below 12 and sold above 20.

4.India: The CAPE for India (25.6) is high both in absolute terms and relative to the country’s history, reflecting a good GDP growth profile in a world with scarce growth and investor enthusiasm. At this high level return prospects are poor and negative returns are a distinct possibility. Indian stocks should be bought in the high teens and sold in the high twenties.

5. Brazil: At the current CAPE (9.4) history points to potentially high returns, but not without risk of disappointment. The ideal entry point for Brazil is below 8 and the market should be sold around 18.

Korea: The CAPE for Korea (6.4) is low both in absolute terms and relative to the country’s history. At this CAPE level high returns are likely and negative returns are a low risk. Korean stocks should be bought below 10 and sold in the high teens.

5.Taiwan: The current CAPE for Taiwan (14.9) is cheap. Future returns appear attractive but Taiwan has a turbulent stock market history, a highly cyclical market and geopolitical risk, so caution is advised. Taiwan should be bought below 15 and sold above 20.

6.Mexico:The CAPE for Mexico (15.3) is in neutral territory, implying fair valuation. The market should be bought in the low teens and sold in the mid twenties.

7. Philippines: The current CAPE (13.1) is on the low side and offers the prospect of high returns with some risk. The market should be bought below 15 and sold above 25.

8.Turkey: The current CAPE (6.9) is low in absolute terms and relative to the country’s history and offers the prospect of high returns, made more likely by the recent momentum. Nevertheless, this is always a very risky market with turbulent macroeconomics and politics and short cycles. This market should be bought below 10 and sold above 15.