4Q 2023, Expected Returns in Emerging Markets

Emerging market stocks underperformed the S&P500 in 2023, for the sixth year in a row and the ninth  out of the last ten years. This leaves the valuation premium of the S&P500 at its highest level since the peak of the previous tech bubble in 2000. The U.S. market appears to be enjoying a blow-off, driven by a consensual view on an immaculate soft-landing for the U.S. economy and optimism on future AI-fueled productivity growth.

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 depicted 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. The chart shows markets from left to right based on how cheap they appeared a year-end 2022. By and large, cheap paid and expensive did not, with the U.S. and India being the two outliers, both going from very expensive to even more expensive.

For 2024, Turkey, Taiwan and the Philippines look compelling. In addition to being “cheap,” their economies are in the early phase of the business cycle and earnings are expected to be strong.

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.