Uncertainty about the value in emerging markets persists as investors question whether today represents a worthwhile entry point. Declines in emerging markets year-to-date have taken valuations back below 1.5x book value. This reflects a healthy dose of scepticism given the myriad uncertainties and rising anxiety about the impact of a stronger US dollar on emerging market concerns.
However, these valuation levels are also the area around which long-term investors may wish to add exposure, as the one- and three-year forward returns from these levels tend to be quite rewarding in both absolute and relative terms.
How can investors know when it is time to buy? We are looking for three catalysts to demonstrate emerging markets are on a sustainable path to performance recovery.
First, investors need to look for stable emerging market currencies. As we can see in the chart below, a number of EM currencies have been weakening since 2011, culminating in the so-called ‘taper tantrum’ last year. However, we would argue that the prevalence of floating currencies across emerging markets is an important legacy of prior crisis, allowing deficits to move accordingly. We can see here that most of the currencies are now below fair value or clustered around fair value, suggesting that recent weakness is more a function of US dollar strength and less intrinsic to weakness in emerging markets. In effect, this is creating a sort of floor. Look for currencies to continue to stabilise.
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Second, investors need to look for emerging markets to ‘recouple’ with developed markets. This is correlated to our first point about currency weakness. In recent years, EMs have struggled relative to their developed market counterparts because of the widening gap in economic performance trend. Average emerging market earnings have disappointed expectations, not keeping up with developed markets and causing their relative market performance to suffer. This is a divergence from the normal long-term pattern of correlation, in which the respective economies generally moved together.
However, there is evidence this is starting to turn, helped by improving exports and global trade, suggesting EM will come back into synch with developed markets. This is where we would differentiate between the manufacturing economies and the commodity driven economies. As shown in the chart below, manufacturing oriented countries are leading the way in improving exports. Clearly we’re still in the early stages of this recoupling process, but we can point to early evidence that recoupling may lessen the drag on EM economic and earnings growth.
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Third and most importantly, the bottom line for emerging markets is that earnings expectations need to improve. Investors should consider this the most important catalyst and should recall that as a purchaser of shares you’re not buying GDP growth, but rather you are buying earnings per share and dividends per share growth of companies.
As illustrated in the chart below, there remains a large gap between expectations and reality and this gap will need to close. We will be looking closely to see margin improvement as domestic economies gain momentum.
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That third catalyst in our view should be considered alongside valuations, which are not a catalyst per se but certainly an important traffic signal.
When price-to-book (P/B) values have fallen below 1.5x, the MSCI Emerging Markets Index has historically registered double-digit returns over the following 12 months, as illustrated below. In other words, what you pay for an asset class tends to be the defining feature of your return profile. The lower the entry point, the higher the prospective returns.
In answer to whether emerging market investors should fear a rising US dollar, research conducted by our Market Strategists on EM equity prices show that historically they’ve had a very strong negative correlation with the trade weighted dollar. This is because a strong dollar has tended to go along with weaker commodity prices and capital outflows from emerging markets. There is also a currency translation effect, which lowers the dollar value of EM earnings. But now, especially, it is important for investors to note that not all of emerging markets will react in the same way to a strengthening US dollar. It is also possible that EM assets as a whole will have a slightly easier ride during this strengthening cycle, because energy and basic materials now represent a smaller proportion of the index than in some previous periods of dollar strength.
As illustrated below, on a 10-year time horizon, our analysis suggests that emerging economies in EMEA have a -0.31 correlation with the US dollar, compared to the MSCI Emerging Markets Index, which has a -0.82 correlation. Based on our analysis, Latin American emerging markets are likely to fare less well, having a -0.86 correlation. But even there, we are likely to see exceptions (see the case of Mexico, below).
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Overall, a significant strengthening of the dollar could provide a bumpy ride for emerging markets in the months and years ahead. But differentiation is the name of the game. As shown below, some emerging markets with economies linked to global supply economies—and especially the US consumer—are likely to fare better during this period. And some, such as Mexico could fare very well indeed.
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In summary, recent volatility in markets reminds us why valuation discipline and patience are so important when investing in a cyclical asset class such as emerging markets, particularly at a time when the growth drivers that typically support emerging markets remain elusive.
There are always unforeseen risks in emerging markets and it is an asset class driven more by sentiment and confidence than others. Admittedly there is still no proverbial green light. Can valuations go lower? Can currencies fall below fair value? Yes, they can, but a cyclical asset class with high volatility is a buy in these circumstances for investors with a one-to three-year horizon.
Buying EM is neither obvious nor popular, which may be precisely why today’s markets may offer an opportune entry point for the long-term investor. History teaches that equities rise before economic growth and earnings turn. Those investors who wait for a pickup in earnings and stronger growth miss a substantial portion of the upside that drives the longer-term return profile of a cyclical asset class such as emerging market equities.
