Emerging Market Valuations After the Crash
The ongoing correction in asset prices worldwide may be a boon to opportunistic investors with cash and a long-term view. Emerging market stocks which started the year at low valuations relative to history are now even more attractive, and in some countries at fire sale prices.
We look at expected returns below. We assume that 2020 is a lost year, with scarce growth anywhere in the global economy. Also, we consider that most countries will see economic recovery in 2021 and 2022 and that earnings will recover to trend. The first chart shows the current projections based on the close of March 16. The second chart shows the projections made at year-end 2019.
This exercise has proven useful in the past, particularly at times of extreme valuations such as we see today. However, the projections are based on a simplistic model with the following premises:
- We look at where each individual country is in its earnings cycle and we assume a normalization of earnings over a two-year period. We then project that normalized earnings will grow at the rate of nominal GDP through the target-period, which in this case is seven-years. Given the nature of the model, expected returns don’t vary greatly if the target period is extended to 10 years.
- We use cyclically adjusted price earnings ratios (CAPE) to determine the target value of the market. The historical average CAPE ratio for the market is used as the multiplier for the CAPE Earnings of the target year, which gives us the target market price for the target year.
- The model will fail when the historical CAPE ratios prove to be irrelevant and/or if the simplistic earning projections are far off the mark.
A few comments are in order:
- Valuations have improved dramatically almost everywhere. The US is now valued almost in line with its history and can be expected to provide return only moderately below historical levels.
- In EM only Thailand is on the expensive side.
- More than half of the EM markets are heavily discounted and now offer the prospect of very high returns. Colombia, Chile, Turkey, Philippines, Korea and Malaysia offer the prospect of extraordinary returns.
- Global emerging markets now offer nominal returns of 12.5% annually, still about two times the expected returns for the US market.
- Returns for emerging markets could be significantly higher if the USD enters into a weakening cycle and/or commodities recover from the current decade-low prices.
Great article.
I would like just to make a small typo correction: the first table is showing “March 2019” and it should be “March 2020”.
Hello Sir,
I have a few questions:
1. Assuming CAPE is somehow correlated with long term expected return, how large is volatility of distribution for a country like Turkey let’s say? So if the earnings yield is 1/CAPE=25%, which is the worst case scenario for a 10 year holding in your humble opinion?
2. Which is the difference between 7 year nominal vs real total return? The difference seems very small in your assumptions and from what I know Turkey has issues with inflation. Moreover, I’ve heard that most EM currencies are now at a 17 years low. Please correct me if I’m wrong.
3. Do you think EM equities are a screaming buy right now or we should still be cautious as currencies have collapsed and we see large outflows? How would you position in these volatile markets? Would you begin to average down with a buy and hold approach?
4. MSCI Turkey has a 10 year annualized return of -2.42%. Do you have any information if it had high CAPE at the beginning of the 10 year period? If yes, I would be more optimistic regarding the next 10 years for Turkey. However, right now it seems it’s very close to the bottom level of 2009 and has only generated 5.46% since 1998. I know that past performance is not a predictor of the future, but I need to know how accurate CAPE is for making a good prediction and for us to be in margin of safety.
5. Are historical correlations useful anymore in a highly correlated market when we have exogenous shocks? Except China which had a small drawdown so far, all countries where I’m invested are down a lot. What do you think particularly of Brazil and Russia which have had a large drawdown and were affected of the oil price war as they are net exporters? Are you confident in those areas or would favor countries like India, South Korea or Turkey short term which may profit from lower oil prices?
Thanks for your questions, Victor.
1. Difficult question. My experience is that markets with CAPE below 5 and more than one std dev below long term averages have a high probability of meeting elevated expected returns. The risk of negative returns is low, but certainly not zero, and would require a breakdown of historical mean reversion patterns.
2. All numbers are in USD, assuming 2% CPI.
3. I think EM is very inexpensive and has very high expected returns for the next decade. However, the short-term environment is negative for EM and may be quite stressful, so I am waiting for better entry.
4. Turkey traded at a CAPE over 15 in 2020, compared to 4x today.
5. I expect we will enter into a reflation trade in 2021, so commodities and EM in general will do well.
@jvande So basically, you’re confident about EM future expected returns, but you are trying to time the market by not entering now? Would you think it’s wrong to start averaging down from these levels? I was thinking to start buying some countries like Russia, Turkey and Brazil which seem really depressed. Which is your model for deciding when to enter the markets?
Which EM countries are you particular optimistic about when it comes to a 10-year real annualized return forecast and how would that impact portfolio construction? Are you going to overweight certain countries or hold an equally weighted basket of EM equities? I’ve found an aggregate ETF for EM offered by Franklin Templeton. It’s called LibertyQ Emerging Markets UCITS ETF. Would that be useful for capturing the risk premium across main EMs or would you rather advice for customizing a more particular portfolio of certain countries? For instance, I wanted to have decent exposure on Singapore, Malaysia, Thailand and other Asian countries since I’m expecting a secular bull run in Asia, while developed markets are doomed to secular deflation due to demography, low interest and inflation.
Best Regards,
Victor Vulpescu