Strategy Note /

Emerging market equities are cheap and reflect well known risks

  • Many immediate concerns for EM equities: dollar strength, higher US rates, slowing China growth, global de-coupling

  • But, a price for everything: EM equities and FX rates generally cheap relative to historic average, more so than in US

  • Positive factors in EM investment case and longer-term risks too but focus on these after valuations partially recover

Emerging market equities are cheap and reflect well known risks
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

Tellimer Research
4 October 2022
Published byTellimer Research

There are many immediate concerns for emerging market equities but most of these are well known and reflected in cheap valuation of equity indices and currencies.

  • The MSCI EM index is down 27% in the last year, with similar declines in MSCI FEM and FM, whereas the US S&P 500 is down 13%.

  • On trailing Price/Book, EM is on a 20% discount to the 5-year median, whereas the S&P is at par.

  • Most large emerging markets exhibit a market capitalisation to gdp ratio ("Buffet indicator") below the 10-year average, whereas the US is at par.

  • The US real effective exchange rate is at a 17% premium to the 10-year median, whereas China and India are at 5% premia, and South Korea and Brazil are at 10-15% discounts.

Emerging market equities valuation de-rating

Most of large EM cheaper than US on Buffet valuation indicator (MC/GDP), relative to history

Dollar well above historic average value unlike large EM FX

Many immediate concerns in EM equities

There is little immunity across the emerging markets, as an asset class, from the headwinds confronting the global economy:

  • US dollar strength;

  • Rising US interest rates and government bond yields (higher cost of funding for all and generally lower risk appetite);

  • Chinese slowing growth (a mix of the hangover from a debt and property boom and continuing zero-Covid strategy);

  • Higher inflation and slower growth in the EU (triggered by the Russia-Ukraine War and tardy central bank policy)

  • Elevated food, and, to a degree, fuel prices;

  • De-coupling of of various strands of the globalised system of trade and finance (US-China friction on trade and technology, isolation of Russia via sanctions, the growth of alternative payment systems out of China, India, and Russia); and

  • Climate change induced natural disasters (eg heat waves and floods in China, India, and Pakistan).

Chronic distress cases are exceptions, not the norm

In some cases, these global headwinds are compounded by poor policy choices or the starting position of excessive external debt. But the list of Argentina, Lebanon, Nigeria, Pakistan, Russia, Sri Lanka, Turkey, and Zimbabwe among emerging equity markets, is one of exceptions rather than the rule.

Even in this list of policy "bête noires", cases where there is almost a pathological level of self-destruction as opposed to merely sluggish structural reform as seen in the likes of Brazil, Egypt, India, Malaysia, South Africa, there are stuttering steps back to orthodox policy under the assistance (and politically painful but necessary constraints) of the IMF (Argentina, Pakistan, Sri Lanka).

And, after the expulsion of Argentina (in 2021 due capital controls), Russia (in 2022 due to sanctions), these are markets that are also now, collectively, fairly trivial when it comes to weight in MSCI EM (under 45bps, with Turkey the sole remaining constituent), and even in MSCI FM100 the weight is under 13%.

However, there is a price for everything

The better we can articulate the problems and risks and the more that is accepted as consensus wisdom, then more likely they are priced into assets.

In that context, we review where emerging markets stand in terms of valuation. From a top-down perspective, we consider valuation relative to history of both equity market indices and currencies.

In our presentation of country index data on price/book, price/earnings, and REER, we segment large EM (countries with about a 2% weight or more in MSCI EM) and small EM (the long tail of about 15 other countries in EM, the entire FM universe, and the non-classified markets like Argentina and Zimbabwe).

Emerging markets generally cheaper versus history than US

US Dollar has more valuation downside than most EM FX

Focus on longer-term risks when valuations recover

Longer-term term there are generic challenges for emerging markets, such as how to:

  • Escape the "middle-income" trap once the early gains from sorting out law and order, improving life expectancy, electricity provision, and education, and adopting sensible macroeconomic policies have been realised;

  • Create a manufacturing export base before the onslaught of automation and 3-D printing re-shore industrial activity back to developed markets (where the richest end consumers are located);

  • Liberalise financial and capital markets without becoming a hostage to volatile foreign portfolio flows; and

  • Address inequality (in economic opportunity and political representation) and political succession without spooking the politically entrenched elite into become a reactionary, obstructive force.

But these are concerns to focus on when valuations return to well above historic average levels, not at this point.

Positive reasons for investing in EM equities too

This report has focused on the negative factors affecting EM equities and to what degree these might be reflected in valuation. We have written separately about the positive reasons, in addition to valuation, for investing in EM equities, centred around the growth themes of:

  • Manufacturing ("China plus 1"),

  • Commodities (renewable energy transition),

  • Tourism (post-Covid recovery), and technology semiconductors, IT services and "super apps").

The one positive theme that has been relegated in the list of government policy priorities amid management of Covid, tighter global liquidity, and slower global growth is structural reform.

For the most recent iteration of those equity strategy views, please see our last regular monthly report, linked here.