Even financial analysts who are bullish on the US recovery will acknowledge that equity valuations are high and long maturity bonds don’t look terribly attractive, but that still raises the question of where investors should be looking for value. The Eurozone periphery, which has given the best developed market gains so far this year, and some currently out of favor emerging markets could be the key to finding good investment opportunities.

German valuations skew Eurozone average

Eurozone equities have lower valuations overall than US equities, but the periphery is even cheaper because Germany pushes up the average.

“Once adjusted for sector differences, German equities are significantly more expensive than most peripheral equities, and only fractionally cheaper than the US,” writes Barclay’s analysts Jim McCormick, Guillermo Felices, Michael Gavin, Sreekala Kochugovindan, and Tal Shapsa in a March report on asset allocation. “We stick with our overweight in European equities but continue to emphasize there is better value away from Germany.”

The Barclay’s report compares countries on a SCAPE basis, which is similar to CAPE but it also controls for the differences in sector mix from one market to another. Southern Europe is even cheaper than many EM markets, and you basically have to move to frontier markets to find lower valuations than Greece. Investing in Russia is politically risky now for obvious reasons, but the Barclay’s analysts don’t expect the annexation of Crimea to have a systemic impact on Europe’s recovery.

barcalys Eurozone

CAPE Shiller PE
‘Normal’ CAPE’ according to Meb Faber Research

EM bond yields high relative to corporate Baa, equities at recession era levels

Moving beyond the Eurozone completely, EM equity price-to-book valuations are nearly as low as they were during the financial crisis, having diverged from the MSCI EM Price Index in 2009. The potential slowdown in China and impact of Fed tapering is weighing on EM equities almost as heavily as the actual financial meltdown, which suggests that stock prices are unreasonably low.

EM valuations near crisis level 0414

“Many EM fixed income markets are as attractive (if not more so) than their respective equity markets,” says the Barclay’s report. “We believe EM looks an increasingly tempting choice for tactical and quite possibly strategic overweights.”

Overall, dollar-denominated Baa-rated EM debt has generally tracked Baa-rated US corporate debt yields in recent years, but corporate yields have been falling since mid-2012 while EM bond yields started rising again last year. Breaking bond yields down by market, bonds appear to have more attractive prices than equities in some EM markets (Hungary, Brazil) and could be a good place to look for cheap assets.

EM earnings less bond yields 0414

EM USD bonds less US corp 0414