For over a decade earnings and earnings multiples have declined for emerging market stocks, leading to very poor returns both in absolute terms and relative to the S&P 500. Over this period, these markets went from “bubble” conditions in 2010-2013, fueled by the commodity super-cycle and the rise of China, to the current depressed state which reflects slowing growth, Covid, geopolitical risk and global financial instability caused by high debt levels and a rising USD.
We can see this evolution in the following tables. On the left, Cyclically Adjusted Price Earnings (CAPE) multiples are shown for the S&P500, EM stocks (MSCI) and a sample of emerging market countries. Note the contrast between the sharp rise in the U.S. and the decline in most emerging markets, with the exception of the tech-centric Taiwan. On the right, dollarized MSCI EM earnings are rebased to 100 in 2010. Here we see the striking contrast between surging earnings in the U.S. market and the flat to negative earnings in EM, once again except for Taiwan (TSMC). Even China, with its supposedly high GDP growth, strong RMB and enormously successful tech stocks, has seen no earnings growth over this period.
Predicting the future evolution of geopolitics, Fed policies and the other myriad factors that impact economies, capital flows and stock markets is always a daunting challenge for investors. For this reason, it is often best and easiest to assume that historical patterns of valuation and mean reversion will persist. In this regard, we can use CAPE analysis to provide a basis for valuation parameters. Though CAPE is not a short-term timing tool, it has proven effective in predicting long term returns. This is particularly true at market extremes, like 2010-2012 when CAPE was screaming “bubble” across EM.
The CAPE takes 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. We use dollarized data to capture currency trends. This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University.
The chart below shows CAPE ratios for 16 EM countries, global emerging markets (GEM, MSCI) and the S&P500 relative to each country’s history. This gives a general idea of where valuations are on a historical basis for each country. Extreme discrepancies from historical patterns are currently evident in the U.S. and India on the overvalued side. Most emerging markets appear to be very undervalued; Turkey, Korea, Colombia, Philippines and Chile are at extremes.
In the table below we show the results of our adjusted CAPE methodology for estimating future expected returns. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns. The two columns on the far right show (1) the expected nominal return for each index and (2) the real (inflation adjusted) expected return for each index with the addition of expected dividends.
The methodology derives expected returns by setting a long-term price objective based on the expected CAPE earnings of the target year, which in this case is 2028. The CAPE earnings of the target year are multiplied by the historical median CAPE for each country. The underlying assumption of the model is that over time markets tend to revert to their historical median valuations.
The countries with very low expected returns (Indonesia, U.S., Thailand and India) each have their specific issues. Given the stretched valuation, Indian firms will have to surprise the markets with better than expected earnings growth. The U.S. faces the challenge of high CAPE multiples, record corporate operating margins and declining potential GDP growth. Thailand and Indonesia are reasonably priced and could enjoy higher returns if GDP growth surprises on the upside. This would require a boost in productivity to break out of the current trap these countries face, stuck between new low-cost competitors (e.g. Vietnam) and China’s industrial might.
The five markets with the highest expected returns (Turkey, Brazil Colombia, Chile and Peru) are all in countries with significant economic and political concerns. In the case of Turkey, the destitution of President Erdogan is probably necessary for these returns to materialize. As for the Latin American countries, political stability and high commodity prices would make these returns likely.
Taiwan’s high expected returns require a recovery of the semiconductor cycle, which is likely. Also, investors have to be comfortable with rising geopolitical risk in the Taiwan Strait.