Emerging markets have endured a torrid year, losing more than a quarter of their value since peaking in January. Investors are often advised to buy when there is blood in the streets and to be greedy when others are fearful, so is it time to increase allocations to emerging markets?
Or is this a value trap, with apparently cheap emerging market stocks being cheap for a good reason? A whole host of difficulties have beset emerging markets this year. A strong dollar and rising US interest rates, a US-China trade war, economic slowdown in China, rising oil prices, increased political and economic turmoil in countries ranging from Argentina and Brazil to Turkey and South Africa – these and other issues drove the Morgan Stanley Capital International (MSCI) emerging market index into bear market territory (a peak-to-trough fall of at least 20 per cent) in August. And the bloodletting has not let up since then, with emerging markets losing some $1.1 trillion in 2018 and suffering their worst year since 2011.
Buying on the cheap
For investors, the question arises as to whether this bloodletting has created an opportunity for long-term investors looking to pick up stocks on the cheap. Emerging markets have badly underperformed US indices for almost a decade now, notes State Street Global Advisors. This performance gap has driven a marked divergence in valuations so it “makes sense” to overweight the cheaper region and underweight the more expensive US market. The valuation gap has been noted by many other money managers. Price-book ratios indicate emerging market equities trade at a 36 per cent discount to developed world stocks, Neptune Investment Management noted recently. That’s one of the widest discounts recorded over the last decade and it has historically proven to be a strong buy signal, with emerging markets tending to strongly underperform over the following five-year periods. Cyclically-adjusted price-earnings (Cape) ratios, too, suggest a lot of bad news is already priced into emerging market stocks, with fund management group
Research Affiliates
noting the region’s Cape ratio is less than half that seen in the US market.
"EM [emerging market] stocks are comparatively cheap when measured by Cape, price-to-book ratio, price-to-sales ratio, market cap to GDP, and other metrics", it says, adding that investors should be buying rather than selling "when fear reigns supreme". That's echoed by GMO, the famously contrarian money management firm headed by legendary value investor Jeremy Grantham, which argued in August that emerging market stocks are the "most attractive" asset for long-term investors by a "large margin".
And while most advocates are stressing that emerging market stocks look like a sound long-term bet, there may also be a short-term opportunity, according to JP Morgan’s chief quant, Marko Kolanovic, who reckons a 15 per cent rally over the next six months is likely as developing markets close the performance gap with their US counterparts.
Some caveats
There are some important caveats, however. First, emerging market stocks soared last year. And sceptical observers point out they have not yet given up all of those gains, which hardly suggests they are trading at bargain prices today. Second, the current Cape ratio is only slightly below historical norms; the huge valuation gap with the US market largely reflects the latter’s apparent priciness as opposed to emerging markets being especially cheap. Third, it makes sense that emerging markets are cheaper than US indices, given the latter are dominated by high-growth technology stocks boasting high profit margins while emerging market indices are more weighted towards financials and commodity stocks. According to FTSE Russell’s Philip Lawlor, emerging market stocks trade at a discount of about 20 per cent compared to their developed world counterparts but this differential disappears when one accounts for their sectoral make-up.
This is not like early 2016, says Lawlor, when emerging market indices traded on a "double discount". Data from Blackrock, the world's largest money manager, seems to confirm that selling has been far from indiscriminate. The 10 poorest performers in the MSCI emerging market index account "for nearly 40 percent of the hit,", says Blackrock. Of those 10 stocks, eight are Asian and six are from China, with the list dominated by technology giants such as Alibaba, Samsung, Baidu and Tencent.
Outside of this narrow group of stocks, selling appears to have been contained rather than frenzied. Clearly, not all money managers share the idea that emerging market stocks are obviously cheap, while others say they are cheap for good reasons. The Bats – Bloomberg’s acronym for Brazil, Argentina, Turkey and South Africa – all have obvious problems, with the four countries burdened by weak currencies, high inflation, high debt and increased political tensions. In Indonesia, the rupiah has fallen to its lowest level in 20 years, while trade tensions with the US continue to worry investors in China.
Companies in emerging markets are “particularly vulnerable” to trade tariffs, says GMO, which admits it is “appropriate” for investors to be concerned about “escalating trade tensions”. In any event, even long-term bulls will admit that cheap stocks can get cheaper. The valuation gap between the US and emerging markets has been noted throughout 2018, but it continued to widen until the global selloff finally spread to America in October. Research Affiliates’ aforementioned advice about buying “when fear reigns supreme” was penned in June, but things have got much worse since then.
Last December, Jeremy Grantham called on investors to “be as brave as you can on the emerging marketfront”, saying he had invested 55 per cent of his family’s pension fund in emerging markets. Unfortunately for him, investing too early can be a very costly business. Grantham’s GMO colleague Ben Inker admitted in the firm’s August letter that the previous quarter had been “painful” and advised bottom-fishers to be prepared for further pain, given that momentum is a powerful force in emerging markets. Still, bulls are hopeful a bottom is not far away. JP Morgan’s emerging market FX index, which tracks the main emerging currencies against the dollar, recently hit a record low. Merrill Lynch’s October monthly fund manager survey also suggested that currency risk may be receding, with a record number of professional investors now viewing emerging market currencies as undervalued.
Investor exposure
Whatever about the short-term outlook, a strong case can be made for having some exposure to the region. Although more volatile than developed market indices, emerging markets have delivered strong long-term returns and have provided important diversification.
They now account for about 12 per cent of global stock market capitalisation (up from only about 1 per cent 30 years ago, when investment opportunities were far more limited) and more than half of global GDP. Bulls and value investors would suggest overweighting one’s portfolio with emerging market stocks, given long periods of underperformance have historically tended to be followed by above-average returns. Nevertheless, investing at the bottom is a rare thing indeed; investors with a long-term focus should accept only the very luckiest of souls manage to time the turnaround.
