- Long-term investors have a unique investing opportunity in emerging market assets given the very rare combination of cheap equity valuations, depressed currencies, and positive momentum in equity prices and economic fundamentals.
- Even after the strong rebounds in emerging market assets since January 2016, which ended prolonged bear markets across the asset class, expected real returns over the next decade are still very attractive.
On the rare occasion when a hockey player scores three goals in a single game, fans throw their hats into the rink to acknowledge the feat, called a “hat trick.” The term originated over 150 years ago on the cricket pitch in the United Kingdom: the bowler who retired three batsmen with three consecutive balls was awarded a new hat. Today’s sports fans have evolved the practice into literally pummeling the goal maker with hundreds of hats. What has not evolved, however, is the rarity of the achievement.
Just as the unusual occurrence of three goals triggers the throwing of hats into the hockey rink, today’s similarly rare combination of exceptional valuation levels, depressed currencies, and powerful momentum—both price and economic—should encourage long-term investors to “throw their hats” into the emerging markets rink.
We emphasize long-term investor because it’s impossible to possess the clairvoyance to perfectly time the markets. Most of the volatility in shorter-term price changes is unpredictable noise. By contrast, long-term returns are mostly a function of yield, plus growth, both of which can be estimated with increasing accuracy as we look further into the future. Accordingly, at Research Affiliates we focus on gauging which assets and currencies are priced to deliver attractive returns over longer horizons, all while using shorter-term price and economic momentum as a barometer for the conviction in our expectations of future returns. Let’s dig a little deeper.
The investment community seems largely unaware of just how cheap emerging market (EM) assets have become as a result of a multi-year bear market that appears to have ended in early 2016. In January 2016, we characterized EM equities as “the trade of the decade.” The January lows were by all accounts exceptionally low. As far back as we have good data, we find only 24 non-overlapping instances—after screening 24 developed and emerging market countries—in which the Shiller P/E of a country’s equity market dipped below 10.0x. Even rarer is the Shiller P/E of an entire region dipping below 10.0x.
Driven by extremely cheap (and likely well-deserved) valuations in Brazil, Russia, Poland, and Turkey, the Shiller P/E of the MSCI Emerging Markets Index dipped below 10.0x in January for the first time since the index’s inception, settling just shy of that low at 9.6x to close out the month. With a 19% rebound since then, some investors might think they’ve missed the rally and it’s now too late to invest. They may want to reconsider.
The recent rebound in EM equities from February through November 2016 is tracking the average experience, and if history is any guide, the path of least resistance indicates more upside to come. The asset class may not deliver the additional 100% return over the next four years consistent with the average historical experience, but it’s by no means impossible. Even after this year’s rally, EM equities are trading at a depressed Shiller P/E of 11.2x, still well below the 13.0x observed during the darkest days of the 2008 global financial crisis.
Rather than rely on past averages to forecast future returns, we use a building-block approach that adds current yield, likely long-term growth in income, and some mean reversion in valuation multiples to create forward-looking returns. This method, available at the Research Affiliates Asset Allocation website, indicates a 10-year real return for capitalization-weighted EM equities of 7.5% a year—and was as high as 9.0% a year in January!
It gets better. Although the Research Affiliates Fundamental Index™ (RAFI™) is well known for having a value tilt, the fact that its value tilt is dynamic is much less well known. When value equities are not so cheap, the tilt is mild, but when value equities are strongly out of favor, the tilt deepens considerably. Value equities—currently dominated by financials, energy, and basic materials—remain very much out of favor in emerging markets.
Today, the FTSE RAFI™ Emerging Markets Index trades at a Shiller P/E ratio of 9.9x, and that’s after a 32% rebound since January and over 21% outperformance versus the MSCI EM Index! If we compute the Shiller P/E on the individual stocks in the index at the end of November (a bottom-up calculation), the P/E of 7.4x for FTSE RAFI EM is quite astonishing. As you might expect, our forward-looking return expectations for the FTSE RAFI Emerging Markets Index—and its derivations—remain significantly higher than our forecasts for the cap-weighted MSCI EM Index. But for those with patience, fundamentally weighted EM equity exposure is unlikely to disappoint in the coming decade. Of course, this is for the entirety of a 10-year window. We know the path to outperformance won’t be linear.
EM equities are not alone in their promise of outperformance. EM local debt, represented by the JPMorgan GBI-EM Global Diversified Index, is also attractively priced. At the end of November, the index is trading at a yield of 6.8% compared to developed market debt, proxied by the Barclays Capital Global Aggregate Bond Index, which is offering a scant 1.6%, also as of the end of November. This 5.2% yield spread is well into the top decile of the historical range and well over the historical average of 3.9%. The Research Affiliates 10-year real-return forecast for EM local debt at the end of November is 4.3% a year, net of default risks. In a zero-yield world, that’s a huge win.
A common link between EM equities and EM local debt is the currency exposure. Based on our relative purchasing power parity (PPP) model, EM currencies tumbled from 25% above fair value in 2011 to 30% below fair value in January of this year. Even after this year’s rebound they remain about 19% cheap to the US dollar. If EM currencies’ relative valuations strengthen just halfway back to historical norms, such a move would translate into a near 1.0% tailwind to yearly returns over the next decade.
Although EM currencies, represented by the JPMorgan Emerging Local Markets Index Plus, have rebounded since January 2016, they continue to trade near the discounts associated with the 1997 “Asian Contagion” and 1998 Russian debt default. EM currencies can certainly get cheaper before they revert toward historical norms, but they might just as easily snap back quickly to fair value. Our relative PPP reversion expectations with high EM cash rates, a faster growing working-age population, and continued productivity growth as EM economies “borrow” technological advances from developed economies, all support our projected real return for EM currencies of 3.9% a year over the next decade.
Positive Momentum: Price and Economic
Today, EM stocks are trading cheaply and showing robust 12-month price momentum. This positive positioning combined with improving underlying economic fundamentals in EM economies provide investors a good opportunity to increase allocations to this arena.
Price momentum. Obviously, an acknowledged tension exists