Valuations in Emerging Markets

The current environment appears unattractive for emerging market equities (The Outlook for 2018). Nevertheless, for those disposed to stand pat and allow time to deliver the long-term returns and diversification benefits of investing in emerging markets current valuations are compelling enough to remain invested.

Over the short-term (1-2 years) valuations are not he main driver of stock performance. Liquidity, driven by monetary policy and human psychology are much more important over the short term. This is well expressed in this  quote from the legendary investor Stan Druckemiller:

“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

However, over the long term valuations do matter. As Ben Graham once said: ““In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Valuations do matter and they are the key driver of long-term performance. So, where are we now with vauations in emerging markets?

At the end of June, emerging market equities remained inexpensive relative to their own history and very cheap compared to the S&P 500. As the table below details, EM equities trade at about half the level of the U.S. market on a price-to-earnings basis and are even much cheaper on the basis of a cyclically adjusted price-to-earnings ratio (CAPE; price divided by 10-year average inflation-adjusted earnings).  While the S&P500 CAPE is priced at one standard deviation above its recent 15-year average, the EM CAPE is well below its 15-year average. Compared to their own history, EM equities are relatively cheap while the U.S. stock market is very elevated.

 

 

The work of two prominent firms that recommend allocation strategies — GMO and Research Associates – points to the same conclusion.  GMO, in its most recent 7-year forecast recommends EM for its relative attractiveness. As shown in the chart below, GMO sees real (after inflation) annual returns of 2.4% for the next seven years for EM and -4.4% for the S&P500.

Research Affiliates projects similar outperformance for EM, with 6.7% real annual returns for the next ten years from EM, compared to 0.3% for the S&P500.

These attempts at projecting future returns are, to a large degree, based on the assumption  that valuations revert to historical means over the long term (7-12 years).

Country-specific Valuations

Emerging markets are a very broad asset class, so it is not surprising that valuations vary greatly  across the markets. One of the main reasons for differences in valuations is that sectorial composition  is not consistent across markets. Because of this, it is generally more useful to compare valuations to a country’s own history rather than to other countries or EM as a whole. This works for most markets but not all. For example, historical comparisons are largely irrelevant in China which has a short trading history and a rapidly changing market structure (10 years ago industrial state companies dominated the market; today private tech firms stand out).

In any case, the charts below rank key emerging market countries in terms of valuation. The first group consists of markets that are valued well below their own history and therefore stand to offer high upside for the future. The second group have low valuations and can be expected to provide above average long-term returns. The third group of countries have relatively high valuation and should provide more modest returns in the next 7-10 years.

The markets with low valuations include several countries – Turkey, Russia and Brazil – that have recently experienced turbulent political disruptions which have caused economic distress and a loss of investor confidence. Argentina is in a similar situation. These markets may require a break with the past through elections or transformational reforms for market recovery to occur. For example, if a reformist leader is elected in Brazil this year, this could provide a trigger for the market to recover strongly.  On the other hand, Colombia, Chile, Malaysia and Indonesia already appear poised for stock market appreciation.

 

 

One-Year Positioning    

 To rank markets in terms of attractiveness for the next twelve months we look at valuations,  and macro and liquidity factors.  Each factor is scored from 2 to -2 for each country. The macro factor measures where a country is in its business cycle; and the liquidity factor looks at credit and flows. Results are shown below. Scores of three and above indicate relatively positive prospects.

 

 

Fed Watch:

India Watch:

  • Samsung opens world’s largest smartphone factory in India (Bloomberg)
  • Scarsity of visas is shaking up Silicon Valley (SF Chronicle)
  • India’s national strategy for artificial intelligence (NITI.Gov)
  • A look at the value factor in the Indian stock market (Indexology)

China Watch:

China Technology Watch

  • Tesla’s move to Shanghai (FT)
  • Tesla’s China plan (NYtimes)
  • Daimler and Baidu get ahead on driverless cars in China (Reuters)
  • China wants high-tech cars with German help  (NYT)
  • The battle to build the next super-computer (Tech Review)
  • America’s war on China tech (FT)
  • China tech start-ups lead VC funding (SCMP)
  • Shanghai aims to raise $15 billion for AI investments (SCMP)

EM Investor Watch

Tech Watch

  • Seven reasons why the internal combustion engine is dead (Tomraftery)