Emerging market stocks have continued to underperform the S&P500 over the past year and the past quarter, as global capital flows to the safety of U.S. assets in a world of rising economic instability and risk aversion. However, below the surface interesting trends are emerging that point to better days ahead.
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 has outperformed the MSCI EM core index by 3% over the year, and, more importantly, the cheapest countries in the EM index are now by far the best performers. This is in stark contrast to the past five years when cheap only became cheaper and rich only became richer. We can see this in the chart below which shows the performance of the four cheapest markets in EM relative to the MSCI EM index. Turkey (TUR), Brazil (EWZ) and Chile (ECH) have beaten the EM index by huge margins over this period. Colombia (GXG), which recently elected a leftist anti-business president, has still managed to perform in line with the market.
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 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) takes 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 today, have historically 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. Aside from Turkey, Colombia, Philippines and Korea look very cheap on this basis. 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.