The Next Ten Years in Emerging Market Stocks

  Investors in emerging markets had very poor returns in 2018, experiencing losses of 14.5%. Nevertheless, over the past decade, EM total annualized returns in USD (including dividends) have been a reasonable 8.4%. However, retruns in EM stocks have been dismal compared to those of U.S.  equities.As the chart below shows, during the past decade EM equities returned a total of 90% which compares to a 240% return enjoyed by investors in the S&P 500. . We can look at relative valuations to explain this relative performance. The chart below looks at Cyclicaly Adjusted Price-earnings (CAPE) ratios for both EM and the S&P 500. (The CAPE takes an average of ten-year  inflation-adjusted earnings to smooth out cyclicality). This poor EM performance occurred because at the beginning of the period valuations in EM were relatively high and U.S. valuations were relatively low. The chart shows that a year-end 2008 EM was trading at a CAPE multiple 0f 14.7, in line with its 15-year average. Meanwhile, the U.S. market was valued at a CAPE mulitple of 15x, compared to its 15-year average of 26x.  By the end of the 10-year period, EM CAPE multiples had declined and were well below historical averages while U.S. multiples were well above the historical average. This largely explains the relatively strong returns of the S&P 500 for the 2008-2018 decade. As a reminder, the previous decade 1998-2008 had been an entirely different story, with EM vastly outperforming the stagnant U.S. market.  During the 1998-2008 period, EM CAPE multiples expanded and U.S. mulitples contracted. In fact, if we look at the past twenty years EM stock market performance is far ahead , providing returns of 444% vs. 204% for the S&P 500, as shown in the gaph below. So, what can current valuations tell us about probable future returns? In short, the prospects look good for EM.  EM is now relatively cheap, trading at a CAPE valuation of 11.7 vs. a 15-year average of 16. Meanwhile, U.S. stocks trade at a CAPE of 28.4 times vs. an average of 24.7x. The U.S. dollar has also been strengthening for years against EM currencies, a trend that is likely to revert in the future. Though, in the words of baseball legend Yogi Berra, “it is difficult to make predictions, especially about the future”, we can use the historical context to make some guesses about probable future returns. We make three assumptions: 1. Valuations will move back to the historical CAPE average over the next five years; 2. Earnings return to historical trend; and 3. Normalized earnings grow by nominal GDP. To determine the historical earning trend we take a view of where we are in the business-earnings  cycle. In the case of EM we consider that at this time earning are about 10% below trend and we assume 6.5% nonimal GDP Growth (vs. 4% for developed markets). Based on this simple framework and assumptions we project annualized returns for EM stocks for the next five years of 9.8% (9.3% for ten years).   Adding dividends, we project total annualized returns of 12.1% (10.5% for ten years.)  The U.S. ,by contrast, is likely to experience multiple contraction and is at peak earnings, so that returns can be expected to be low single-digits. Two outside opinions shown below arrive at similar results: first GMO (on the left) projects 4.4% real annualized returns for EM (7.9% for EM value) for its seven-year forecast period; Research Affiliates (link) arrives at at 9.6% annualized nominal return for its 10-year forecast. On a country-by-country basis, as one would expect, great differences appear. Countries find themselves at different points in the business-earnings cycle and their valuations may vary greatly depending on the mood and perceptions of investors. The chart below shows where country-specific valuations stand relative to the 15-year CAPE average for the primary EM markets. The third column shows the difference between the current CAPE and the historical average. For example, Turkey’s valuation, in accordance with CAPE, is 60% below normal. The markets in the chart are ranked in terms of probable long-term returns (5-10 years), with the last two columns to the right  estimating annualized total returns (including dividends) for the next five and ten years. The table also shows where markets are currently in their business-earnings cycle and expected annualized earnings growth for the next five years. What does this table tell us? First, we can see that valuations are generally low.  The majority of markets in EM trade at very deep discounts. India, Peru and Thailand, the most expensive markets, are valued only slightly above historical valuations and are not abnormally high in absolute terms. Second, most markets stand  in the early-to-mid part of the earnings cycle. This provides the opportunity for concurrent earnings growth and multiple expansion for Brazil, China, Chile, Mexico, Malaysia, Colombia and Turkey. What does the table not tell us? First, this methodology serves best as a long-term allocation tool, not as a timing tool. Market timing is difficult because short-term stock movements are determined much more by liquidity considerations and the mood of investors than by valuation. So, for example, timing a stock market recovery in Turkey is not easy. The market may fall much further before it starts a recovery. Eventually, a new more constructive narrative will gain traction in Turkey and catch the  attention of investors, starting a new cycle. Second, the assumptions of the model may be wrong.

  • Historical CAPE valuations may be a poor guide, either too high or too low. Only the future will tell.
  • Earnings projections also may be wrong. Earnings may or may not return to trend, and can err in either direction. For example, the return forecast for Brazil assumes a return to the earnings trend and 5% annual nominal earnings growth between 2019-2023. This could be much too conservative if the new government achieves its planned ambitious free-market reforms; on the other hand, it may be too optimistic if the reforms are not introduced and the fiscal situation gets out of hand.

 Trade Wars

India Watch

  • India’s potential in passive investing (S&P)
  • India’s food-delivery startup, Swiggy, backed by Tencent (SCMP)
  • Modi’s election troubles (WSJ)

China Watch:

  • Zero growth in car sales expected for 2019 (Caixing)
  • Looking back on 40 years (Ray Dalio)
  • China steps up bullet train spending (scmp
  • On sector investing in China (Globalx)
  • The Future Might Not Belong to China (FT)
  • Will China reject capitalism (SCMP
  • The rise of China’s steel industry (WSJ)
  • Nobel economists comment on Chinese model (ECNS
  • Learning from China’s development model (scmp)
  • China debates economic policy (FT)
  • China is stepping-up infrastructure investments again (Caixing)
  • China’s radical experiment (Project Syndicate)

China Technology Watch

Brazil Watch

  • John Bolton’s Troika of Tyranny (The Hill)
  • The rise of evangelicals in Latin America (AQ)

EM Investor Watch

  • Koc Holding’s digital transformation (Mckinsey)
  • Lowy Institute Asia Power Index (Lowy
  • In pursuit of prosperity (Mckinsey)
  • What drives the Russian state? (Carnegie)
  • Russia’s big infrastructure bet (WSJ)

Tech Watch

Investing