The Outlook for Emerging Markets Stocks

 

As discussed in prior posts (stormy-waters-in-emerging-markets ), the environment for emerging markets investing has deteriorated since January of this year. We are in the midst of a typical “risk off” phase for global liquidity, which causes investors to seek the safety of dollar assets. This is happening after a period of historically low interest rates which lured many EM countries into borrowing in dollars. Turkey is the poster child for this moment, having as it has for several years funded a construction and consumption boom and large current accounts deficits with dollar-funding provided by yield-hungry foreign investors.

Poor Global Liquidity is Bad for EM Equities

The current rise in risk aversion has several explanations, all of which have led to a strengthening dollar, poor global liquidity  and pain for EM.

  • A huge, late cycle fiscal expansion has boosted U.S. GDP growth at a time when both China and Europe have experienced unexpected economic slowdowns.
  • Rising inflation expectations are leading the U.S. Fed to move forward to “normalize” monetary policy, resulting in significantly higher long-term interest rates and growing spreads between U.S. yields and those of Europe and Japan. Inflation expectations are rising because of economic overheating, rising tariffs and supply chain disruptions, and high oil prices.
  • President Trump’s anti-globalization policies and the unilateral “take it or leave it” approach to diplomacy is increasing tensions and forcing companies to reconsider investments.

Global dollar liquidity is now declining. In essence, dollar supply is tightening, which makes it difficult for dollar borrowers to repay loans and for global trade to grow. Chart 1  below shows the year-on-year change in dollar liquidity, measured by combining the U.S. monetary base with Foreign Central Bank Reserves. While global GDP is growing at above 3% per year, the data shows that dollar liquidity has been growing by less than 1% this year, a steady decline from the 8% growth achieved in 2012.  Chart 2  below shows that reserves held by foreign central banks also peaked in 2012. It is not a coincidence that the dollar has persistently strengthened  against EM currencies since 2012. This rise of the dollar against EM currencies is shown in Chart 3.

Chart 1. Year-on-year increase in global liquidity (IMF,FED)

Chart2. Dollar Reserves held by Central Banks (FED)

Chart 3. EM currencies against the U.S. dollar (MSCI, Yardeni Research)

Valuations are Compelling

Though current conditions of tight global liquidity and a rising dollar are detrimental for EM equities, valuations are compelling.  When global liquidity conditions improve, EM equities can provide high returns from current levels. Valuations are now at very attractive levels,  both in absolute terms and relative to history and alternative asset classes. As shown in the table below, expected dollar real returns for the next 7 years are in the order of  9.5% annually, which compares to 6% real returns (before dividends) experienced over the past three decades. These expected returns are estimated by assuming mean reversion for both valuations and earnings to historical trend lines and assuming earnings growth to be in line with GDP growth.

Similar exercises by GMO (Link) and Research Affiliates (Link) reach slightly different conclusions but all point to significantly superior returns in EM relative to other asset classes.

 

 

Conducting a similar exercise within the EM universe, we can rank from a quantitative viewpoint the expected returns of individual markets. The first chart below shows valuation parameters for major EM markets. The final column shows the gap between the current cyclically adjusted price earnings ratios and the historical “normalized” level for each market.

Finally, the table below ranks EM countries in terms of expected future returns from current levels. Not surprisingly, recent problematic markets such as Turkey, Colombia, Indonesia and Russia appear to be priced very low compared to their histories. As always, investors tend to extrapolate the recent past and find it very difficult to imagine a return to historical trends.

India, which until very recently was the market darling, also looks very attractive again., assuming it can deliver on very high expected GDP growth (IMF estimates) and return to higher earnings multiples.

Expensive markets, such as Taiwan, Thailand, Peru and the Philippines, all trade at multiples that are above historical norms and have enjoyed powerful earnings cycles that are also well above trend.

 

Macro Watch:

  • New NAFTA shows limits of “America First” (WSJ)
  • NAFTA to USMCA – What in a name? (Lowy)
  • Market Insights for a tripolar world  (TPWIM)
  • Robert Zoellick on China (Caixing)

India Watch

  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)
  • Measuring Indian equities (S&P)
  • Modi is no populist (Foreign Policy)

 

China Watch:

  • Chinese U.S. investments plummet (SCMP)
  • China-U.S. ties now driven by conflict and containment (CSIS)
  • VP Pence’s cold war China speech (NYtimes)
  • U.S.-China trade relations forever broken (SCMP)
  • The U.S. will lose its trade war with China   (Project Syndicate)
  • Hong Kong mainland bullet-train link opens (WIC)
  • China’s embracement of Russia (SCMP)
  • MSCI to step-up A-share inclusion (SCMP)
  • Trump prepares new China attack (Axios)

China Technology Watch

  • Most Chinese patents are worthless (Bloomberg)
  • Chinese provinces keen to attract EV investments (Caixing)
  • How China sustematically steals technology (WSJ)
  • China and India lead the surge to renewables (FT)

EM Investor Watch

  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)
  • Brazil’s social media election (FT)
  • SPIVA Latin American Scorecard (S&P)
  • What the crisis in Venezuela reveals (Project Syndicate)
  • Brazil’s polarized election  (Lombard Odier)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

Investing