Introduction
The MSCI EM index is up 20% from its bottom last October, but is almost 30% below its February 2021 peak. Thus, it has lagged other major markets globally. We have seen and heard investors getting more positive on emerging equities and reallocating capital accordingly. The reasoning goes something like that: 1) the US Fed is close to the end of its tightening cycle and EM are poised to perform once the Fed pivots and starts cutting rates; 2) US equities have performed well and valuations are starting to look stretched at 20x P/E for the S&P500, while EM equities are cheap at around 11.5x P/E; 3) the US dollar will be on a downward trajectory from here and EM currencies are bound to benefit, boosting returns in the process. Let’s review these in order.
The Fed and EM – are we at the precipice of a massive rally?
The first argument is predicated on the expectation that the Federal Reserve will start cutting rates aggressively in the not-too-distant future. While nobody expects rate cuts in 2023 anymore, the market is pricing six rate cuts in 2024 that will bring the Fed Funds Rate to about 3.75% from the current 5.25%. Without agreeing with or refuting this forecast, let’s consider the conditions for it to materialize. First, we need to have (core) inflation firmly at the 2% target level and, second, the state of the labor market should pose no risk of a wage-price spiral developing. Given the most recent CPI readings, and the still very low unemployment rate, that would require a meaningful growth slowdown of the US economy, and possibly of the rest of the world. Would that be good for EM markets? Most likely not.
Looking at the period from year-end 2007 through mid-year 20231, the MSCI EM index was highly corelated with the US 5-year break-even inflation rate.2 The relationship was so strong that the R-squared statistic between the two was 0.51 and the correlation was 0.723. During the same period, the MSCI EM index returned only 1.3% annualized, including dividends.4 In other words, for more than 15 years the index was essentially flat, but volatile, with moves higher as inflation expectations rose, and moves lower when inflationary expectations declined. The rationale for this behavior is that the emerging markets both as economies and as an asset class are highly dependent on global growth and liquidity conditions. Inflation expectations rise when those two are on the rise, and vice versa. Back to the current state of affairs, if the Fed is likely to start cutting rates aggressively, it will most likely be because global growth and liquidity conditions are deteriorating and hence inflation expectations will most likely be declining. Historically, this has not been a positive backdrop for emerging stocks.
Are EM equities cheap?
With MSCI EM at forward P/E of 11.5x and P/B of 1.6x, the short answer is yes, they are cheap. And they always have been – these numbers are bang in line with long term averages. Looking at fundamentals, we find the MSCI EM index with expected ROE of 12% and EPS growth of 18% yoy in 2024. While this growth looks good year-over-year, earnings will be essentially at the same level as in 2021, so there will be no earnings growth over the three-year period. As far as the ROE, 12% does not look that exciting to us compared to the 18% ROE of the S&P500 and the 5% risk-free yield on US T-bills. With median P/E over the past 10 years of just over 11x, we don’t see a strong case for a multiple rerating from here.
To be clear, above we discussed the valuation of the index overall; as such, the numbers will be driven by the largest markets by weight in the index. The largest country by far is China, followed by Taiwan, India, and South Korea. China is cheap at a P/E of less than 10x, while India is not quite, at almost 20x P/E; South Korea is cheap at 10x P/E, while Taiwan is at 15x P/E. There is a great dispersion among countries when it comes to valuation and fundamentals. But an index mutual fund or an index ETF will be giving investors what the index offers, net of fees of course. If they want to do better, investors need to dig deeper and rely on the good old stock picking.
Are EM currencies the ultimate hedge against potential dollar weakness?
Currencies historically have been very important return factor for EM asset classes. Overall, weakening dollar has been positive for EM markets. The latest evidence is the period 2002-2007 when the DXY index depreciated by almost 40%. That was the last period of strong EM outperformance. But this period coincided with booming Chinese economy and record commodity prices. In the absence of these two factors, a potential leg down in the US dollar may not be as unequivocally positive. Over different (longer) time periods the evidence is mixed. Dollar denominated bonds issued by EM countries and corporations have provided better absolute returns than investing in local equity or fixed income markets. There are wide disparities here as well: the weakest currencies have been in Latin America, Africa, EEMEA, and South Asia, whereas Central Europe and North Asia (including Taiwan) have faired much better. This division mostly reflects relative GDP per capital levels. Put simply, less developed economies tend to be lower value-added exporters and depend on weak exchange rates for their growth and for balance of payments sustainability. Some have had at times egregious macro policies centered around money-printing. Further, the DXY index is heavily skewed towards the EUR/USD and USD/JPY rates. Even if the Euro and the Yen appreciate further vs. the dollar, not all EM currencies may go along for the ride. Relative fundamentals will drive each currency performance.
Conclusions
EM equities have lagged the strong recovery of the US and European equities. One reason has been their weak earnings recovery compared to other markets.
Global environment characterized by Fed tightening, falling inflation expectations and possible global growth slowdown has not been conducive historically to EM equities outperformance. EM valuations are optically cheap, but in line with long-term averages. Lack of further earnings and profitability improvement will likely keep overall multiples from rerating. Even in a dollar weakness scenario vis-a-vis the Euro and the Yen, it should not be an automatic assumption that all EM currencies will strengthen in tandem. Some may, but many may not. Investors should be discriminating and not buy the asset class wholesale via index funds or ETFs. Better opportunities may exist at a country or a stock level, but investors need to do the work to find these. The ancient Roman rule caveat emptor (buyer beware) holds true more than ever.
Mihail Dobrinov, CFA
CIO, Trimon Capital Management, LLC
[email protected]
1 We take this period as it is bracketed by the end of the China-driven rally of EM which peaked at the end of 2007. We consider these to be unique conditions that are unlikely to repeat.
2 This is calculated by subtracting the real yield of the inflation linked maturity curve from the yield of the closest nominal Treasury maturity. Source: Bloomberg.
3 Regression was run on weekly values. Monthly values provided very similar result. Source: Bloomberg
4 Source: Bloomberg.
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