Emerging market stocks ended the second quarter badly underperforming the S&P500 and the MSCI All Country World Index (ACWI) year-to-date, as well as for the past one, three, five and ten years. There had been some hope during the first quarter that rising inflation and interest rates would squash long duration assets like U.S. tech and give a chance for value stocks and emerging markets to outperform. However, this was short-lived. By the end of the second quarter, interest rates were collapsing, U.S. tech stocks were leading the way again and American exceptionalism was reaffirmed by the U.S. indexes hitting record levels at near-record valuations.
The second quarter and the year so far, therefore, brought more woes for emerging markets. Momentum has been the primary force for markets, driving the expensive stocks higher and the cheap stocks lower. We can see this clearly in the charts below which show (1) country returns YTD for EM and (2) expected returns based on relative cyclically adjusted price earnings (CAPE) ratios.
With the exception of Brazil and South Africa, two countries benefitting from positive terms of trade shocks from rising commodity prices, the countries with the highest expected future returns (Turkey, Philippines, Peru, Colombia. Indonesia, Chile and Malaysia) are also the ones with the lowest returns for the period. On the other hand, the expensive countries with low expected future returns (India, Korea, Russia, Mexico, Taiwan) continue to outperform. Of course, the United States, the most expensive of any market around the world, provided stellar returns of 14.9% during the first half of the year.
Unfortunately, the countries with very inexpensive markets relative to their history are not helping themselves. Sadly, none of the “cheap” markets currently provide a positive narrative for investors. In addition to the pandemic which continues to wreak havoc across EM, many countries also face deteriorating political and economic fundamentals which would justify lower earnings multiples than a relative cape ratio methodology implies. We could argue that the growth prospects for Brazil, Chile, Colombia, Peru and South Africa have deteriorated enough over the past decade to justify lower CAPE multiples. In many cases, historical CAPE multiples may have been distorted by the stratospheric-level valuations reached during the 2007-2012 EM bubble. It may be that some of these markets need to trade at much lower multiples to become attractive investments, say more in line with Turkey today (4.4 CAPE). Arguably, investors should be very cautious at deploying capital until a positive narrative can be developed in these countries.
This leaves us with very few markets to focus on. In Asia, which is where almost all the growth in GDP and consumption will occur over the next decade, Indonesia and Malaysia have good growth prospects and political stability. Their CAPE ratios are cheap in both relative and absolute terms and promise good future returns. Moreover, we can see in the following chart that they both have competitive currencies and good economic fundamentals. The Philippines also appear attractive, given low valuations and a good growth profile, but have an overvalued currency and weaker fundamentals. In Latin America, Mexico also has a nice combination of an attractive CAPE valuation, competitive currency and good economic fundamentals.
The best opportunity in EM stocks today is in Turkey which has the compelling combination of very low CAPE valuation and undervalued currency. The patient investor would be well advised to build positions ahead of an eventual change in government or economic policy.