Expected Returns in Emerging Markets

After a decade of poor returns in emerging market stocks, the asset class suffers a crisis of credibility. But, cheer up;  prospects for future returns have improved.  As we enter the new decade, we may be diametrically opposed to where we stood a decade ago when  EM stocks were expensive and U.S. stocks were cheap.

Investors in emerging market stocks had total returns of 18.5% in 2019, ending a dismal decade on a positive note. Total returns (including dividends) over the past ten years have been just 4% per year, which is well below the historical average of 10.3%. EM net returns also have paled in comparison to those of the mighty S&P 500.  As the chart below shows, over the decade the S&P 500 provided total returns of 253% compared to 33% for the MSCI EM.

The chart below provides some perspective by showing performance for the S&P500 and the MSCI EM Index by decade.

Investors suffer deeply from “recency bias,” the tendency to believe that market trends will continue. This means that today there is a strong bullish consensus on the rising U.S. market and pessimism on the relatively weak emerging markets. However, if we are patient and can take a longer term view, we can expect that valuation fundamentals will weigh heavily on stock prices, triggering a process of mean reversion. Because of this, rational investors take a long-term probabilistic view of capital allocation, assuming that over an extended time-frame (e.g., 7-15 years) mean reversion is likely to play out. While Wall Street enthralls the public with bold annual forecasts, long term investors should develop a humble and long-term view on the probability of future outcomes.

Any analysis of historical returns shows that, over the long-term, stock prices have two drivers:  earnings and the multiple on earnings that investors will pay. Earnings are generally driven by GDP growth, though over the short to mid-term they are affected by business cycles and corporate margins. The relationship between earnings and GDP is the basis for Warren Buffet’s favorite stock market valuation indicator (S&P500/GDP).  Multiples vary depending on the mood and risk-taking appetite of the investment public and also on the level of interest rates (lower interest rates lead to higher multiples). Multiples also are sensitive to inflation. The low inflation and negative real interest rates of recent years are the main reason for the high multiples that we see for U.S. growth stocks.

Capital allocators estimating long-term probable returns generally  must take a simplistic view. In terms of earnings they will try to establish a normalized level which adjusts for business cycle effects. Future multiples are assumed to revert  to historical levels, or at least move in that direction. There is no standard way of doing this, and each practitioner may do it slightly differently, but in general results tend to be similar. In the charts below we look at the current expected return forecasts made by two prominent asset managers/allocators: GMO (Link)  and Research Affiliates (Link).

Both GMO and Research Affiliates expect emerging markets stocks to be the star performers over the forecast. GMO expects 4.5% real annual returns for EM and 9.3% for EM value and negative 4.4% for U.S. large cap stocks. Research affiliates sees 6.8% real annual returns for EM and o.3% real annual returns for U.S. large caps over the next ten years.  Star Capital, a European asset manager, reaches similar conclusions, estimating expected real returns for the next 10-15 years to be 7.6% for EM and 2.8% for the U.S (Link).

We conduct a similar exercise with a focus on emerging markets. Our forecast is for 6.2% real annual returns over the next seven-year period and 0.8% real annual returns for the S&P 500.

We make three assumptions: 1. Valuations will move back to the historical CAPE average over the next seven years; 2. Earnings return to the historical cycle-adjusted trend; and 3. Normalized earnings grow by nominal GDP. To determine the historical earning trend we take a view of where we are in the business-earnings cycle. We calculate the historical average CAPE by taking a weighted-average of the CAPE-ratio for the past 15 years (75%) and the CAPE-ratio over the entire period that data is available (25%)

On  a country-by-country basis, as one would expect, great differences appear. Countries find themselves at different points in the business-earnings cycle and their valuations may vary greatly depending on the mood and perceptions of investors. The chart below shows where country-specific valuations stand relative to the  CAPE average for the primary EM markets. The third column shows the difference between the current CAPE and the historical average CAPE. For example, Turkey’s valuation, in accordance with CAPE, is 40.5% below normal. The markets in the chart are ranked in terms of probable long-term returns (7 years). The table also shows where markets are currently in their business/earnings cycle.

We can see that valuations are generally low in emerging markets.  The majority of markets in EM trade at CAPE ratios which are below average, and Turkey, Malaysia, Chile and Argentina are heavily discounted. On the expensive side, only Thailand stands out. The contrast with the U.S, is striking. While 10 years ago the CAPE ratio in the U.S. was well below normal, today it is more than one standard deviation above normal.

The methodology assumes a stable dollar, meaning the dollar will neither appreciate nor lose value relative to the basket of currencies represented in the MSCI EM Index. The actual trajectory of the dollar will have a big impact. The experience in emerging markets is that a weak dollar generates liquidity and higher earnings growth, as well as higher multiples. If the dollar were to lose relative value over the forecast period it is probable that returns in EM would be significantly higher. This is particularly true for commodity-exporting countries like Brazil which would experience liquidity windfalls.

Furthermore, we can expect markets to overshoot both on the up and downside. Forecasts assume a return to normalized historical statistical trends, but markets can be expected to surpass those levels as enthusiasm builds momentum.

In conclusion, allocators should consider increasing positions in emerging markets where returns will probably be relatively strong in coming years.