Emerging market equities have been trading at a steep discounts to the developed market for some time now, implying that the risk in those markets is abnormally high (or the risk in DM is unusually low). But most according to Barclays analysts Joao Toniato and Ian Scott, most measures of risk don’t back this up and EM equities could be poised to outperform.

“With EM equities trading at a c. 28% discount to DM and a c. 23% discount to their 10-year average (in terms of P/Book), we believe few investors would argue against the idea that emerging market (EM) equities are relatively cheap,” write Toniato and Scott.

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Relative EM volatility below long-term average

Volatility is usually higher in EM than in DM, but after a recent spike it has actually come down to about 1.2x compared to a long-term average of 1.3x. Relative volatility is only loosely correlated with the EM/DM real yield gap, but the low level of volatility certainly doesn’t support the current ERP levels.

Similarly, high risk premia usually comes hand in hand with high levels of stock correlation, but that doesn’t appear to be the case right now, at least when looking at the largest EM stocks by market cap. Again, this probably isn’t the kind of thing you would base an investment on, but the discrepancies add up.

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EM credit markets don’t reflect the same risks

What’s more perplexing is that credit markets haven’t priced in the same level of risk as equity markets. The EM/DM corporate yield gap has been range-bound since 2010, but the real yield gap started rising in late 2012. The difference between these two curves seems to contradict the two most common explanations for why investors are staying away from EM equities: tapering and fears of a hard landing in China. In both cases you would expect to see a reaction in both yield gaps (even if not to exactly the same degree), but credit markets are unfazed.

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Finally, ERP in emerging markets is normally dependent on the global economic cycle, which is currently recovering. As long as there aren’t any shocks to bring back fears of a recession, the ERP for emerging markets will be more and more out of sync with global markets, and will eventually need to catch up.

“We find little support for the cheap valuations currently observed in EM in any of these factors,” write Toniato and Scott. “We therefore reiterate our overweight recommendation for emerging market equities.”

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