The US equity market has been regarded as expensive for many years, both in absolute terms and relative to other stock markets. In contrast, emerging markets look better value. But are emerging markets really that cheap?
Over the past five years we’ve often received questions from our clients about why our exposure to emerging market equities has been low. At times, we’ve held close to zero exposure in stocks from the developing world.
Our position was based on our analysis of the poor growth dynamics in emerging markets, but also due to high valuations. Simply, emerging markets were attracting a large premium based on expectations that long-term growth would significantly outpace developed markets.
During the late-2010 to early-2016 period, emerging markets consistently underperformed developed markets. As such, emerging market valuations de-rated, especially compared to the United States.
MSCI emerging markets total return – ratio to developed markets (in USD)
But, more recently, emerging markets have started to perform well.
Increased exposure to emerging markets
Earlier this year we raised our holdings in emerging markets to what we regard as a ‘neutral’ level – or long-term average – position. We did this because of better fundamentals, principally improving global trade growth, but also because of reasonable valuations.
As the chart below shows, the emerging market growth premium to developed markets has been unwound. On our two favourite valuation measures – price-to-book and price-to-forward earnings – emerging market stocks look around 30% cheaper than developed markets.
Emerging market equity valuations relative to developed markets
So, on an aggregate basis, emerging market equities look good value. But it is also important to look at valuations on a country-by-country basis, given that often emerging markets look cheap because of lowly valuations in the largest countries, like China and Brazil. Across the 23 countries in the emerging markets universe valuations are 13% below their 20-year average and only 5 have valuations above their own long-term average: Brazil, Egypt, India, Philippines and Thailand. But even among those 5, none of the valuations look overly excessive.
Given lowly valuations, what would make us increase our allocations to emerging markets?
While the global trade cycle looks to be improving, based on our analysis of sea and air freight volumes, we’re not convinced that commodity prices are on a sustained upward path. If we see more encouraging signs on commodity prices, we would expect to raise our holdings in emerging market stocks further.
As with all investing, your capital is at risk. A stocks and shares ISA may not be right for everyone and tax rules may change in the future. If you are unsure if an ISA is the right choice for you, please seek independent financial advice. Past performance is not a reliable indicator of future performance.