Month: January 2023

Emerging Markets’ no Growth Decade

Emerging market stocks have performed poorly for more than a decade both in relative and absolute terms. This can be explained by a marked decline in price to earnings multiples since the very high levels achieved in 2008 and 2012 combined with poor growth in these earnings. In turn, low growth in earnings were caused by a significant deterioration in the GDP growth of most emerging markets.

We show the evolution of multiples and earnings in the following charts.  CAPE multiples are at a third of the level reached in 2008 while earnings have been flat in nominal USD terms.

 

This remarkable result can be explained by the unbalanced growth of the global economy. While emerging markets are said to be growing GDP at a higher rate than developed markets, the growth is highly concentrated in China (and to a degree India). Emerging markets ex China and India have languished over this period. We show this in the chart below.

 

Given the disappointing growth of emerging markets ex China since the GFC,  it is not surprising that earnings growth has been poor. What is stunning is the lack of earnings growth in both China and India, despite their high GDP growth, as shown below.

The explanation lies in the unbalanced nature of Chinese growth, which relies on the repression of the consumer to subsidize the export sector and unproductive state investments in infrastructure and industry. China’s excess capacity is increasingly dumped on emerging markets, leading to deindustrialization, low productivity and low growth.

Using CAPE Ratios in Emerging Markets

 

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side. The Cyclically Adjusted Price Earnings multiple (CAPE) has proven effective in highlighting them.

The CAPE takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings.  We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

CAPE is best used as a long-term allocation tool. However, it is not effective  as  a timing tool. Market timers seeking short-term returns will be more successful using traditional technical analysis to identify trends and paying close attention to investor sentiment and liquidity flows.

CAPE works particularly well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia);  it works less well for more stable economies (e.g., East Asia).

In recent years CAPE has  has been ineffective in predicting forward annual returns. This has occurred because momentum has been more important in determining stock performance than valuation indicators. Moreover, emerging markets started the past decade at very high valuations, and only recently have come to trade at cheap levels and, in some cases, extremely low valuations.

Since  October 2020, we have seen a marked change in the investment environment, with the value factor in both U.S. and international stocks starting to outperform “growth” stocks. Emerging market value stocks have outperformed the EM index by over 20% during 2021-2022. Also, by and large, “cheap” CAPE stocks have started to reward investors. The cheapest stocks on a CAPE basis at the end of 2021 (Turkey, Chile and Brazil) all performed exceptionally well in 2022.

In the charts below we see  what CAPE ratios are currently telling us about future returns based on historical precedents. We map index returns and CAPE ratios for the U.S., GEM (Global Emerging Markets) and the most important emerging market countries (China, India, Taiwan, Korea and Brazil) and also for several countries of interest (Turkey, Philippines and Mexico). The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country specific data is more significant because the CAPE ratios capture better the evolution of the single asset.

  1. S&P 500 :  The market has not provided 10-year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2022 was at 27.3, a level which suggests moderate nominal returns in the low single digits for the next 7-10 years.

  1. Global Emerging Markets. At the current level (15.4) the GEM CAPE provides little insight. The probability of negative or high returns both appear to be low. GEM should be bought below 15 and sold above 20.

3. China’s short and turbulent stock market history provides few data points for CAPE analysis. Nevertheless, the current CAPE (9.5) has provided high returns in the past and points to low risk of negative returns. Chinese stocks should be bought below 12 and sold above 20.

 

4.India: The CAPE for India (25.6) is high both in absolute terms and relative to the country’s history, reflecting a good GDP growth profile in a world with scarce growth and investor enthusiasm. At this high level  return prospects are poor and negative returns are a distinct possibility. Indian stocks should be bought in the high teens and sold in the high twenties.

5. Brazil: At the current CAPE (9.4) history points to potentially high returns, but not without risk of disappointment. The ideal entry point for Brazil is below 8 and the market should be sold around 18.

  1. Korea: The CAPE for Korea (6.4) is low both in absolute terms and relative to the country’s history. At this CAPE level high returns are likely and negative returns are a low risk. Korean stocks should be bought below 10 and sold in the high teens.

5.Taiwan: The current CAPE for Taiwan (14.9) is cheap. Future returns appear attractive but Taiwan has a turbulent stock market history, a highly cyclical market and geopolitical risk, so caution is advised. Taiwan should be bought below 15 and sold above 20.

6.Mexico:The CAPE for Mexico (15.3) is in neutral territory, implying fair valuation. The market should be bought in the low teens and sold in the mid twenties.

7. Philippines: The current CAPE (13.1) is on the low side and offers the prospect of high returns with some risk. The market should be bought below 15 and sold above 25.

8.Turkey: The current CAPE (6.9) is low in absolute terms and relative to the country’s history and offers the prospect of high returns, made more likely by the recent momentum. Nevertheless, this is  always a very risky market with turbulent macroeconomics and politics and short cycles. This market should be bought below 10 and sold above 15.

4Q 2022 Expected Returns for Emerging Market Stocks

Emerging market stocks once again lagged U.S. stocks in 2022, as they have consistently over the past decade.  A rising dollar and persistent economic instability and risk aversion all have contributed to making emerging market stocks a poor asset class over the past year and the last decade. However, there are signs that the environment may be changing. EM stocks are now very cheap relative to the S&P 500, the dollar shows signs of having peaked and, most importantly, investors are looking for real assets that may perform better in a more inflationary environment. EM stocks, which have a high concentration of commodities and cyclical businesses , may be better positioned in the future than they have been in the “growth”-dominant investment world of the past decade.  Moreover, after a decade of poor returns, value investing (contrarian investing in cheap stocks in cyclical industries with little growth) is working again in emerging markets.

The MSCI EM value index outperformed the MSCI EM core index by 5% over the year, and, more importantly, the cheapest countries in the EM index were the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer.

The chart below shows the 2022 returns for all the countries in the MSCI EM index. On the right margin countries in the index are shown ranked in terms of a CAPE valuation based expected returns analysis at year-end 2021, with the cheapest on the top and the most expensive on the bottom. We can see that the cheapest countries (Chile, Turkey and Brazil) were the best performers in 2022 while expensive countries (India, Russia, USA, Taiwan) generally did poorly. The Philippines are one important exception to this trend, having started the year as “cheap” and ended even “cheaper.”

This trend should boost the confidence of EM investors. Emerging markets are by nature a value asset (highly weighted to cyclical businesses) and should not be performing well in an environment of rising risk aversion.  But investors are now betting that these markets are too cheap to avoid because low valuations promise high expected returns that more than compensate for short-term risks.

The chart below shows the current expected returns for EM markets and for the S&P500 based on a CAPE ratio analysis. The Cyclically Adjusted Price Earnings Ratio (CAPE)  is based on 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.

As we have seen in recent years, CAPE is not a good timing tool, but it does tend to work well over time, particularly at extreme valuations.  CAPEs below five, such as Turkey ‘s at the end of 2021, historically have been a failsafe indicator of high future returns. CAPE ratios that are completely out of sync with historical averages for the country are also powerful predictors of future returns.

The table above points to significant opportunities in EM. Global EM (GEM) on its own is cheap relative to the U.S., but more attractive opportunities exist at the top of the chart, particularly in Colombia, Brazil Chile, Taiwan, Peru, South Africa, the Philippines, Mexico, Turkey and Korea, which all promise high returns. Moreover, these countries offer significant, geographical, geopolitical and business cycle diversification opportunities. Colombia, Chile, Philippines and Korea are all extremely cheap relative to their valuation history and are well positioned for business cycle recovery in 2023. On the other hand, India , the most popular market with investors today, is an absolute outlier on the expensive side.

That cheap markets are now performing well in a risky environment is very encouraging for EM investors. If value continues to do well, EM stocks will likely do very well when the coming synchronized global and U.S. recessions hit bottom.