Month: January 2021

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.

 

During the past ten years global stock markets experienced depression-like performance. The aftermath of the Global Financial Crisis was high debt and low growth and ineffective  monetary policy despite huge  money printing and zero interest rates.

The policies of Central Banks only benefited stocks in the  United States where technology and innovation sectors benefitted from low discount rates and earnings were pumped up by tax cuts and stock buybacks. The rest of the world by-and-large saw low earnings growth, declining multiples and weak currencies. Global stocks also started from relatively high valuations and margins, as ten years ago global growth had been highly stimulated by China’s investment boom.

We can see how this developed in the charts below. The first chart shows the performance of the S&P 500 vs the MSCI Emerging Markets stock index. The left side shows the evolution of earnings multiples, the price earnings ratio and the cyclically adjusted price earnings ratio (CAPE, average of 10-year inflation adjusted earnings).  Note the remarkable expansion of the U.S. CAPE from 25 to 34, which is the second highest level in history. At the same time the EM CAPE ratio fell from 20 to 15. The right side of the chart shows the evolution of the indexes and earnings. U.S. earnings were basically flat through 2015 and then took off, and, based on forward PE estimates for 2021, will end about double 2010 levels. EM earnings, based on forward PE estimates for 2021, will be at exactly the same level as 2010. Of course, the combination of the evolution of earnings and multiples explains the dramatic outperformance of U.S. stocks.

The following chart provides some granularity within emerging markets. The same charts as above are shown for three primary emerging markets, China, Brazil and Taiwan. Brazil in 2010 was a major beneficiary of the commodity bubble but since  then has suffered a vicious case of “Dutch Disease,” the natural resource curse. All other commodity producers (Chile, Peru, Indonesia, S. Africa, Indonesia) went through a similar process, though none as painfully as Brazil. Brazil’s CAPE ratio has fallen from 22 to 12 over the period and earnings in 2021 earnings are expected to still be 60% lower than in 2010.

China has seen a significant reduction in its CAPE ratio which went from 22 in 2010 to 11 in 2016 and 16.8 at year-end 2020. Over this period, the Chinese stock market has transformed itself from heavy with banks and industrials to one dominated by tech. These old economy sectors explain the flat evolution in earnings over the period, but in the future technology and innovation stocks will drive results.

Finally, Taiwan is shown as an example of an outlier. Taiwan, like Korea, is a stock market that is dominated by world-class technology companies. Not surprisingly, its CAPE multiple at year-end 2020 was higher that in 2010 and earnings are up over 50% during the period.

2020 may have been a turning point for emerging market assets. At least, all the traditional indicators supporting emerging markets have turned positive: the USD is trending down; commodities are trending up; USD liquidity is abundant; and tolerance for risk is high. Also, emerging markets stocks have started to outperform and ended the year almost even with the S&P 500. Though these trends tend to last, we will need confirmation over the next six months. Still, these conditions are enough to be bullish emerging markets and be fully loaded in terms of portfolio allocation.

The year of the great pandemic will probably be seen as pivotal in that it accelerated existing trends  and starkly highlighted strengths and weaknesses. Good governance was demonstrated by how countries dealt with Covid both in terms of public health policy and fiscal response. It turned out that those countries least able to control Covid were also those most inclined to monetize initiatives to support consumption through fiscal handouts. In many cases (e.g. the U.S., Brazil) these were also countries with weak fiscal positions before the pandemic, and therefore much worse positions by the end of the year. Moreover, those countries that dealt correctly with Covid (almost all in Asia) also represent the manufacturing base of the world, so that money printing to support consumption in developed countries went to Asian exporters. The charts below show total annual returns for the past year and past ten years (MSCI). What we see is that 2020 simply accentuated the trends of the past decade. It was a year when Asia showed all of its strengths (good governance, fiscal probity, commitment to value-added manufacturing, managed currencies) and most of the rest of emerging markets were characterized by dysfunctional politics, incoherent and inconsistent economic policies, and fiscal profligacy.

We show below the returns for the major MSCI EM regions for 1yr,3yr,5yr and 10yr to point out the consistency over time.

We see a similar pattern in terms of currencies in the following charts. Asian economies have been able to maintain their currencies stable and at competitive levels, while most other EM currencies lose value over time and are extremely volatile. Of course, Asian manufacturing benefits greatly from this while manufacturers in countries like Brazil are at a huge disadvantage.

Undoubtedly, Asian stock prices have benefited from exposure to growth sectors, especially technology. Almost 90% of the EM tech sector is based in Asia, with 70% in China alone. As shown below, growth has underperformed in emerging markets, as it has in other regions, because of the scarcity of growth companies in a stagnant global economy and low interest rates. On the other hand, value has performed poorly (Total returns, annualized).

Of course, past performance is not necessarily indicative of the future. Value is now relatively cheap and, due to its cyclical nature, tends to do well when EM does well.  This means that, in spite of secular trends that favor Asia, the rest of EM may actually perform well in a reflationary cyclical emerging market rally. By the way, this would catch by surprise almost all EM actively managed funds that are now largely proxies for Asian tech.