2Q 2023 Expected Returns for Emerging Markets

Emerging market stocks once again are lagging U.S. stocks in 2023, as they have consistently over the past decade, rising by 3.5% during the first semester compared to 16.8% for the U.S. market. The strength of U.S. stocks can be attributed to the resilient American economy and a return of speculative fervor for tech stocks, this time driven by the sudden discovery of the transformative power of “Artificial Intelligence.” Nevertheless, below the surface conditions are also positive for emerging market stocks. Almost all the underperformance of EM stocks can be attributed to China, while most other markets are not doing badly at all. Moreover, EM stocks are now very cheap compared to the U.S. market and value is being rewarded. Also, the U.S. dollar has been on a significant downtrend which, if sustained, will provide a significant tailwind for international assets, including emerging market stocks.

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.   This methodology has been used by investors for ages and has been popularized more recently by Professor Robert Shiller at Yale University. We use dollarized data to capture currency trends. Seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period.  Earnings are adjusted according to each country’s current place in the business cycle and then assumed to grow in line with nominal GDP projections taken from the IMF’s World Economic Outlook.

As expected, “cheap” countries (CAPE ratios below their historical average) tend to have higher expected returns than “expensive” ones (CAPE ratios above the historical average). These expected returns make two huge assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

The second assumption is well supported by historical data if seven-to-ten-year periods are considered, but not over the short term (one to three years).

However, when during certain periods “cheap” markets on a CAPE basis are enjoying short-term outperformance investors should take note, as the combination of value and momentum can be compelling. As the chart below shows, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” would have provided very high returns, even considering negative returns from Colombia. The chart shows Expected Return rankings from one year ago and, in the last column to the right, the total returns over the past year.

That cheap markets are now performing well is very encouraging for EM investors.  To cheap valuations, momentum, and a weakening U.S. dollar we can add the improvement in global business conditions. Almost all EM countries are now in the upswing of the business cycle, a time when they tend to outperform significantly. Moreover, the global economy is also recovering, and the U.S. is expected to achieve a soft landing later this year. This synchronized global recovery should be supportive of cyclical assets like commodities, value stocks and emerging markets.