Expected Returns in Emerging Markets

The global Covid-19 pandemic has had a grave impact on emerging markets. As has happened broadly across the world,  the pandemic has accelerated existing trends and highlighted the strengths and weaknesses of countries and companies. It has also grievously exacerbated income  and wealth inequality in most countries, increasing the divide between the tech-connected “haves” and the disconnected “have-nots.” We can group emerging market countries in terms of how well they have dealt with the virus and the impact that the pandemic will have on GDP growth and public finances. Also, we should differentiate those markets with ebullient tech sectors from those with little presence of tech companies. All these factors have had important ramifications for market performance so far this year and are likely to continue to do so for the foreseeable future.

Taking into account the highly uncertain evolution of the pandemic and its economic and corporate consequences, we live in times when making forecasts is a thankless task.

It may also be senseless when the objective is to identify probable long-term returns in the context of extraordinary monetary and fiscal policies and major shifts in the global trading system.

Nevertheless, we plod on with this exercise in the hope of identifying extreme  valuation discrepancies. As in past efforts (Link ), we assume that valuations will mean-revert to historical levels over a 7-10 year time-frame;  also, we expect that GDP growth and corporate earnings will return to trend over the forecast period; finally, after deriving a long-term earnings forecast, we apply a “normalized Cyclically-Adjusted Price Earnings (CAPE) ratio to determine a price target and expected return. We assume, perhaps naively, that historical valuation parameters still have some validity in a world characterized by Central Bank hyper-activism and financial repression. The methodology has negligible forecasting accuracy over the short-term (1-3 years) but, at least in the past, has had significant success over the long-term (7-10 years), particularly at market extremes.

The chart below shows the result of this exercise. The first thing to note is that, by-and-large,  returns are muted, which is not surprising in a world of declining growth and negative real interest rates. Global emerging markets (GEM) are expected to provide total returns (including dividends) of  6.7% annually in real terms (net of inflation) over the next seven years. This is below historical returns and disappointing in light of the poor results of the past decade. These returns, however, are attractive compared to the dismal prospects for U.S. stocks. The U.S. is trading a near record-high valuations while emerging markets are priced at large discounts to historical valuations.

To secure more attractive expected returns the investor needs to venture into the riskier and cheaper markets. Colombia, Turkey, Chile, Philippines, Mexico and South Africa all trade at very sharp discounts to historical valuations and will provide high returns if mean-reversion occurs. The markets currently are pricing in difficult economic prospects for these markets. However, narratives change quickly. For example, South Africa, Chile, Mexico and Colombia would all benefit from rising commodity prices., and the recent decline of the U.S. dollar and the sharp rise in gold may portend a reflationary trend for the global economy.

There is no hiding from the reality that most assets are priced richly, and investors should not be counting on high returns.

GMO, an asset manager based in Boston, (Link) expresses this clearly in their most recent 7-year forecast for the expected real returns of different asset classes. As shown below, GMO expects negative real returns for most asset classes and a meager 1.6% annually for emerging markets. To garner high returns, GMO recommends investors venture into “value” stocks in emerging markets. This “active” position may be promising because it is diametrically opposed to the positioning of the great majority of “active” investors who are extremely concentrated in “growth” stocks, especially the e.commerce and internet platforms around the world.

This view is also echoed by Research Affiliates (Link), as shown below.  RA’s methodology is similar to the one highlighted above, relying on mean-reversion to historical valuation parameters to forecast expected returns. However, RA is more optimistic on EM stocks, where it expects real annual returns of 7.7%

Our forecasts reflect both the views of GMO and RA. We expect decent, if not stellar, returns for EM stocks, with the possibility of much higher returns if a global reflation trade allows deeply discounted stocks to outperform.