3Q2024, Expected Returns for Emerging Markets

Emerging market stocks outperformed the S&P 500 during the third quarter, primarily due to new promises of economic stimulus from China’s government. However, emerging markets underperformed the S&P 500 during the first nine months of 2024, extending a long losing streak. This marks the seventh consecutive year of underperformance by emerging markets and the tenth in the last eleven years. The recent outperformance of emerging markets, driven by a surge in Chinese stocks, has brought the S&P 500’s valuation premium down to more reasonable levels.

The U.S. market appears to be experiencing a blow-off rally, fueled by a broad consensus on an immaculate soft landing for the U.S. economy and optimism about AI-driven productivity growth. The U.S. market is also benefiting from a remarkable resurgence in profit margins, driven almost exclusively by the “Magnificent Seven” technology giants.

The strength of the S&P 500 can be attributed to both multiple expansion and earnings growth. The recent outperformance of emerging markets, driven by a surge in Chinese stocks, has brought the S&P 500’s valuation premium down to more reasonable levels, but it remains elevated though well below in 2000 or 2015—the last two opportunities to generate extraordinary relative returns in emerging markets. The rising valuation premium over the past three decades reflects the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits.

Earnings growth has been the main driver of the S&P 500’s outperformance relative to emerging markets over the past ten years, as shown below. While emerging markets have been in a prolonged earnings slump, S&P 500 earnings have surged since 2014, largely due to the spectacular margin expansion of the tech giants. Although the strong dollar has contributed, it accounts for only about 20% of the relative outperformance. Thus, the key question for investors is: How much longer can the “Mag 7” phenomenon continue?

The chart below estimates the current expected returns for emerging markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps to smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted according to each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (April 2024).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios.

Nonetheless, when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling. As shown in the chart below, the current environment does not support using CAPE as a timing tool for investment. Over the past twelve months, investing in the “cheapest markets” (on the left side of the chart) has yielded mixed results, working well for Colombia and Turkey but not for Brazil or Chile. Meanwhile, expensive markets (on the right side of the chart), such as the U.S., India, Thailand, and Malaysia, have delivered stellar results. This suggests that, for now, liquidity—not value—is driving performance.

Looking ahead, Colombia, Peru, and the Philippines appear well-positioned to perform, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. However, rising geopolitical tensions and sluggish global growth create a less favorable investment environment. As always, a strengthening dollar indicates the need to remain invested in dollar-denominated quality assets.