The global Covid-19 pandemic has inflicted severe damage on emerging markets. Asia has fared relatively well and will bounce back quickly. However, Latin America and some EMEA countries (Turkey, South Africa) will take years to return to trend growth and are coming out structurally weaker in terms of debt, education and economic prospects.
Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences, making a forecast is more difficult than ever. Nevertheless, we stick to our process and hope that it can provide some guidance for investment decisions.
Our main objective is to identify extreme valuation discrepancies. As in past efforts (Link ), we assume that valuations will mean-revert to historical levels over a 7-10 year time frame; also, we expect that GDP growth and corporate earnings will return to trend over the forecast period; finally, after deriving a long term earnings forecast, we apply a “normalized Cyclically-Adjusted Price Earnings (CAPE) ratio to determine a price target and expected return. We assume that historical valuation parameters still have some validity in a world characterized by Central Bank hyper-activism and financial repression. The methodology has negligible forecasting accuracy over the short-term (1-3 years) but, at least in the past, has had significant success over the long term (7-10 years), particularly at market extremes.
The chart below shows the result of this exercise. The first thing to note is that, by-and-large, current expected returns are muted. This is not surprising in a world of declining growth and negative real interest rates. Global emerging markets (GEM) are expected to provide total returns (including dividends) of 7.5% annually in nominal terms (including inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. Nevertheless, these expected returns are attractive compared to the low prospects for U.S. stocks. The U.S. is trading in CAPE terms at the second highest levels ever while emerging markets are priced slightly above historical averages.
To secure more attractive expected returns the investor needs to venture into cheaper markets. Brazil, South Africa, Colombia, Turkey, Chile, Philippines and Malaysia promise higher returns if mean-reversion occurs.
These expected returns do not assume a major recovery in cyclical and commodity stocks or other aspects of a reflation trade. Early signs of a weak dollar and rising commodity prices since March 2020 have pointed to the beginning of a reflation trade that could be beneficial to EM, particularly commodity producers. In these cycles, EM currencies appreciate and domestic economies benefit from expansion in liquidity and credit, and stock returns could be significantly higher in USD terms.
However, returns may be held back by the high debt levels in many countries and the reality that we are not at low valuations, compared to previous bottoms. The two following charts show the evolution of earnings multiples in EM and earnings, both on the basis of regular annual earnings and in terms of CAPE. CAPE ratios are not nearly as low as during the two previous good buying opportunities in 199-2001 and 2016. Moreover, in terms of CAPE earnings, we are not as depressed relative to trend as during the 2000-2001 recession.
