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.