Category: business cycles

Emerging market stocks have suffered a decade of dismal returns while American stocks have soared. In a previous post (link),  this divergence was  explained by valuations (high in EM and low in the U.S. in 2012) and the appreciation of the U.S. dollar over the past ten years. In addition, U.S. corporations have  benefited from historically low interest rates and tax cuts. All of the factors that benefitted U.S. stocks are likely to eventually revert, which  would lead to a new period of outperformance for international assets. In this post, we look  at this matter in further detail.

The chart below shows the twenty-year performance of the primary emerging market country MSCI indices, as well as the MSCI EM index and the S&P 500. During the 2002-2012 decade, the S&P500 underperformed the MSCI EM Index as well as every major country in the index. The opposite occurred from 2012-June 2023, as the S&P500 soarer while EM languished. Only tech-heavy Taiwan and India managed positive returns over this period.

Two Decades of Index Returns for Emerging Markets and the S&P500

In the chart below,  this divergence of returns is explained in detail by changes in valuation parameters (CAPE ratios, cyclically adjusted price earnings) and dollar-denominated earnings growth. There are two primary conclusion from this analysis. First, CAPE ratios have gone full circle.  S&P500 CAPE ratios started high in 2002, edged down through 2012 and then soared back to very high levels over the past decade. Global EM CAPE ratios started low, went up to high levels in 2012 and then went right back to where they started. As for earnings, for the S&P500, coming out of recession in 2002, earnings growth for the first decade was high and then moderate for the second decade (propped up by low interest rates and tax cuts). EM earnings were very high for the first decade and flat to negative for the second decade, with the exception of tech-heavy Taiwan. (Argentina should be taken with a grain of salt, as numbers are distorted by exchange controls)

The last column to the right in the chart above shows expected returns for the next seven years. The three countries with the highest expected return -Colombia, Chile and Turkey – have returned to the valuation levels they had in 2002 after reaching very high levels in both 2007 and 2012. Brazil’s CAPE ration went from 5.1 in 2002 to 12.9 in 2012 (after peaking at 32.1 in 2007!) and is now at 9.7. Similar to Brazil, the Philippines and Peru now have CAPE ratios well below 2012 but not nearly as low as in 2002. The two most expensive markets – the S&P500 and India – have CAPE ratios well above 2005 and 2012, both at near record levels.

Earnings growth in dollars for most EM countries was extraordinarily good between 2002 and 2012 and dismal in the 2012-June 2023 period, even considering the big surge in earnings in 2022 experienced by commodity producers (Chile and Brazil.)  Poor earnings growth is explained by a strong dollar, low commodity prices and intense competition for manufacturing nations  in a depressionary global environment. Surprisingly, despite an appreciating currency and a significant tech sector, China had negative 0.7%  annualized earnings growth during this period.

The expected returns displayed in the chart above assume that earnings will grow in line with nominal GDP growth for all countries. This also assumes that the currencies will be stable relative to the dollar. Given the current direction of China and its large weight in the MSCI Index, this may be an overly optimistic assumption which exaggerates potential returns for global 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.