Emerging market stocks are once again proving to be disappointing in 2023 due to increasing risk aversion. Geopolitical and domestic political factors, along with a strengthening dollar, are causing investors to seek the safety of U.S. blue-chip stocks and cash. Rising interest rates, concerns about a global recession, and weak earnings in many countries are all contributing to bleak short-term prospects. Investors can only find comfort in the expectation of longer-term returns.
The chart below illustrates the current expected returns for EM markets and the S&P500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The 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 position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, October 2023).
As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant 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.
Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).
Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As shown in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. Although Turkey is no longer “cheap,” it was clearly so a year ago and continues to enjoy that momentum. Nearly all the better performers are inexpensive markets. The one exception is India, which, despite very high valuations, continues to attract flows from investors enamored with EM’s “last growth story.” Chile is also an obvious anomaly, as it should be delivering better returns. It is very cheap relative to its history and, being the world’s leading copper producer, offers an excellent hedge against inflation.
The fact that cheap markets are now performing well is encouraging for EM investors. However, rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.