Emerging market equities have “a good chance of massively outperforming” over the next five years, according to analysis by Source, a provider of exchange traded funds.
While an asset manager talking up a market is not unusual, London-based Source’s argument may have some credibility, given that just $330m of its $22bn of assets under management are invested in emerging markets.
Paul Jackson, head of multi-asset research at Source, points to the cyclically adjusted price-to-earnings ratio, known as Cape, which values stocks compared with a 10-year moving average of their earnings.
As of the end of August this ratio was 12.6 in emerging markets, comfortably below its long-run average of 20.2, according to Source, as shown in the chart. Moreover, this Cape reading is lower than in any other region of the world, with Europe ex-UK currently trading on a ratio of 12.9, the UK on 15.4, Japan on 21.4 and the US on 25.7. The global average is 17.8.
While Cape tends to be a relatively long-term indicator, Mr Jackson believes emerging markets should get a more immediate boost from a pick-up in dividend payments.
“A year ago, EM dividends were falling at a year-on-year rate of 20 per cent but are now growing and will soon show a positive year-on-year trend, in our view,” he says.
Mr Jackson suggests the current situation is pretty much the reverse of late 2010, when EM equities were unusually expensive, trading on a Cape of 24.6 versus a global average of 20.7
“Just as EM equities were the most expensive back then and went on to massively underperform, they are now the cheapest and we suspect have a good chance of massively outperforming over the next five years,” he says. “Despite the concern about commodity prices, we feel that EM assets offer genuinely good value.
“Earnings and dividends in EMs have been awful, partly because of the commodity cycle and partly because of recessions [in areas such as Russia and Brazil]. Now momentum is building.”
Questions can, of course, be asked. Tom Becket, chief investment officer of PSigma Investment Management, believes Cape is a useful valuation metric, but only alongside other measures, while market sentiment also needs to be factored in.
“You need to take it with a pinch of salt. I do respect what Capes tell you, but they are not very good at telling you when a market might begin to perform badly or well in the short term. They are part of the ingredients of the pie, not the pie itself,” he says.
Nevertheless Mr Becket adds: “The thing that Capes undoubtedly are telling us is that emerging markets look cheap both in terms of their long-term history and in comparison with other markets, so I think there is an opportunity.”
Mr Jackson’s use of the Cape data — comparing the current level with the long-term average for each region — also throws up a conundrum.
Through this lens, the US market looks about fair value, with its Cape of 25.7 only a little higher than the long-run average of 24.8, while every other region looks cheap. Yet there is a reasonably widespread view that equities, particularly in the US, have been pushed to unsustainable highs by quantitative easing.
Mr Jackson believes the answer to the conundrum is that the Cape measure for the US has been distorted by the dotcom bubble at the turn of the millennium, which raised Wall Street’s average price/earnings ratio markedly.
If the long-run average Cape was calculated using data back to the late 19th century, “you would come to the conclusion that the US is expensive”, says Mr Jackson, adding “normally when it is this high the returns over the next five to 10 years are negative”.
We feel that EM assets offer genuinely good value
Mr Becket is also wary of US equities at current valuations, suggesting that market expectations that earnings will rise 15 per cent next year, after contracting 1 per cent this year, would represent “a miracle akin to what Lazarus experienced 2,000 years ago”.
Mr Jackson also believes the data for Japan are distorted by that country’s 1980s market bubble. By the same token, however, the average Cape reading for emerging markets could be artificially high because of the excesses of the commodity boom. This is magnified by the fact that the average EM Cape reading in the chart is only calculated over the period since 2005, as earlier figures are not available, while the data for every other region are based on the period since 1983.
Mr Jackson accepts that this distortion is a factor, but takes “reassurance” from the fact that, in absolute terms, the EM Cape measure is lower than that elsewhere.
Another glitch is that an alternative valuation measure — the cyclically adjusted price- to-book ratio — tells a rather different picture.
Mr Jackson’s research suggests this measure has greater predictive power than any other single metric, even though it is rarely followed by the market and has “almost no economic content”.
Emerging markets currently trade on a cyclically adjusted book value of 1.76, below the peak of 1.88 in 2013, but above the levels seen in the earliest years of this data series, from 2005 to 2009.
Whatever the data suggest, it is clear emerging market equities are being viewed more favourably than at the start of the year, with investor flows broadly positive in recent months.
Mark Haefele, global chief investment officer at UBS Wealth Management, who is overweight emerging market equities, says: “Profits are starting to stabilise in emerging countries after a multiyear malaise.
“The turnround should be fuelled by reviving economic momentum. Gauges of business activity show manufacturing activity expanding.”
Mr Becket says sentiment has started to improve, albeit from a low base, while “some EM economies seem to be fundamentally better structured than they were a few years ago”, he says, picking out India, which “has gained significant credibility”, and Indonesia, which “has taken some good economic and political steps in the last few months”.
“Earnings of EM companies seem to have been gradually improving of late. The expectations for earnings growth are not ridiculous, although I think they will be high single digit, rather than low double digit. I think emerging market equities look attractive,” Mr Becket adds.
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