By Graham Harman – Senior Investment Strategist, Asia-Pacific, Australia for Russell Investments.
We believe emerging markets (EM) equities offer good value for investors with a longer-term time horizon and appropriate risk tolerance. The asset class is unloved from a contrarian standpoint and there is some evidence of an improvement in cycle factors such as profits growth, policy easing and economic growth. However, there are still headwinds from lackluster growth in the developed economies and China’s debt problems. The outlook for EM equities is turning more positive, or at the very least, less negative.
EM equities kicked off the 21st
century in fine form. Stellar performance saw the asset class lift its share of the MSCI All Country World Index dramatically, from just 4% in the year 2000, to nearly 10% by the end of 2010. “Emergence” was to prove vulnerable to growing pains however. Currency and governance crises, commodity price downdraughts, a strong U.S. Dollar and – in some emerging nations – outright recession, have taken their toll. By the end of 2015, EM’s share of the global pie (MSCI All Country World Index) was back in single digits, and the MSCI Emerging Market USD Price Index was down -42% from its October 2007 highs.
Now, as 2016 unfolds, EM equities are finding their feet. In this note, we look at the reasons for this incipient turnaround in performance for the better; we examine the value proposition that EM offers in what is otherwise an investment landscape almost entirely devoid of value; and we point to developments in the global investment landscape that are establishing a much more fertile basis for ongoing strength.
Source: MSCI World Index and MSCI Emerging Markets Index. Last observation August 2016.
Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment
Some things change, some things stay the same
The fundamentals are changing in EM this year on a range of fronts. One thing that has been a constant over recent years is its standout value. With near-zero cash rates in much of the developed world and around a third of developed market bonds offering negative interest rates, it doesn’t take much to be “less bad” in the value department. But EM equities offer good value on a stand-alone basis, for example:
- The Price-to-Book ratio is just 1.5X as at August 2016. That’s close to half the price (twice the value) of the U.S. equity market based on the MSCI Emerging Markets Index and S&P 500 Index, respectively;
- The year-ahead Price-to-Earnings ratio is just 12.7x (MSCI Emerging Markets Index). That’s a 25% discount to the developed world (MSCI World Index) – despite expected earnings growth in the Emerging world (7% – 8%, consensus IBES estimate for 2016) tracking at a much faster pace than developed markets (0% – 1%);
- The “Cyclically-Adjusted” Price-Earnings ratio (which “normalizes” earnings to “average” levels) stands at 10.5x for EM. The developed market equivalent is over 20x.
Seasoned EM watchers will note that the EM “value” story
has been with us for at least two or three years now, and index (MSCI Emerging Markets Index) performance has been lackluster. Reasonable questions include:
- How do we know that it’s not a “value trap”? and
- What’s the catalyst for the value to be released any time soon?
A key point we can note straight away is that although concerns about EM indebtedness have been with us for a number of years, we draw some confidence from the fact that most of these economies have survived a battery of downbeat growth, over an extended period, without serious mishap.
The key to the “why now” question is a combination of policy easings across the emerging world in combination with a firming earnings story.
There are two more points to note about EM value, under the header of “firmer foundations”.
First, EM equities are still under-loved and under-held by investors. A survey in June 2016 by Bank of America / Merrill Lynch found investors to be more bearishly positioned in EM equities, than they would expect to be about three-quarters of the time. That type of positioning is a solid bulwark for value, because it means potential sellers have by-and-large been shaken out.
Second, it pays to check on profit margins before relying too heavily on standard valuation metrics such as Price-Earnings ratios. In the U.S. equity market (MSCI U.S. Broad Market Index using IBES earnings forecasts), for example, 12-month forward PEs are high at 17.4x as of September 15, 2016. Profit margins are also high (10.4% for the MSCI U.S. Broad Market Index using IBES 12-month forward sales and earnings forecasts) and fading from slightly higher levels as at December 2015. That’s the opposite of the EM experience, where an asynchronous commodity cycle has seen margins drop from 8.5% in June 2010 (12-month forward IBES estimates for sales and earnings, for the MSCI Emerging Markets Index) to 6.1% in March 2016. Recent evidence suggests signs of a bottoming; the EM margin has increased from 6.1% in March to 6.3% as at September 15, 2016.
Historical data is not an indicator of future results.
The bottom line
Taken together, the EM equity story looks increasingly robust, offering genuine value across the full suite of measures. And that’s an eye-catching story, in a world where U.S. equities are looking pricey and a growing number of bond investors are receiving negative interest rates.
Graham Harman is Senior Investment Strategist, Asia-Pacific, Australia for Russell Investments.