Better Fundamentals & Attractive Valuations -
Why Now is a Good Time to Increase EME Exposure
Managers Investment Group
By Michael Zinkand
November 27, 2012
U.S. equity markets have continued to rise during 2012. As of September 30, 2012, the S&P 500 Index was up 16.4%, with some segments of the U.S. market surpassing their 2007 highs. Emerging market equities have also produced decent returns and benefited from increased investor interest. Through September 30, 2012, however, the MSCI Emerging Markets Index has returned only 11.1% in U.S. Dollars year-to-date, compared with 16.4% for the S&P 500. This may be somewhat surprising since ‚Äúriskier assets‚ÄĚ, like small-cap equities and emerging market equities, often lead when stock markets rise. This has not been the case during 2012, but given the greater growth expectations and more attractive balance sheets of emerging markets, many are favoring emerging markets investments over those in developed nations. Conversely, some worry that emerging markets have become too popular with investors and the emerging market ‚Äústory‚ÄĚ is played out. This ManagersInsight highlights what we believe make emerging markets attractive relative to developed nations and why valuations suggest significant upside remains.
Economic growth is a key input to forecasting country returns. Generally speaking, assuming fair valuations, broad market returns should reflect some combination of domestic economic growth, population growth, inflation and changes in productivity. Emerging markets have produced greater economic growth over recent years and, more importantly, are expected to benefit from faster economic growth going forward. (Chart 1)
Over the last five years the average emerging market country, as defined by MSCI, has generated annual GDP growth of 4.2% compared to 1.0% for the average developed market. Neither is robust, but on a relative basis emerging market growth looks very attractive. Equity market returns are generally based on expectations. Looking forward, the average emerging market is expected to grow GDP at 4.6% compared to 2.0% for the average developed country. While greater growth does not necessarily guarantee greater returns, it should provide a tailwind for investors.
The Three Ds (Debt, Deficits and Demographics)
Over recent years, debt and deficit burdens in developed nations have been points of concern for investors and citizens. (Chart 2) U.S. debt issues drove Standard & Poor‚Äôs to downgrade the U.S.‚Äôs long-term credit rating in August 2011. Similar downgrades have occurred throughout Europe. Additional downgrades seem possible if economic growth does not improve and/or governments do not implement austerity measures to limit future spending and counteract growing liabilities.
However, debt issues are not the same across all countries ‚ÄĒ another factor that makes emerging markets attractive relative to developed markets. The average outstanding debt-to-GDP ratio in developed markets is 82%, compared with 43% for emerging markets. The GDP-weighted average comparison is even more striking as the average for developed nations is 108.1% compared with 37.8% for emerging nations ‚ÄĒ a significant difference. (Chart 3)
Additionally, the average 2011 deficit in developed countries was -3.4% compared with -2.5% in emerging markets. The GDPweighted average differential, again, is even larger, with developed nations at -6.7% compared with +1.0% for emerging countries. The GDP-weighted average for developing nations was actually positive during 2011. This trend is expected to continue going forward in light of the greater growth expectations for emerging markets and the long-term liabilities that must be addressed in developed nations.
History shows elevated debt levels can impede economic growth. Economists have warned for years about the negative impact elevated debt can have on growth. This is intuitive, since higher debt generally leads to higher interest expense, which in turn limits the amount of cash available for more productive or necessary expenditures.
Demographic trends are also more favorable within emerging markets. Many developed nations have aging populations that increase long-term liabilities and can create a financial strain on younger workers. (Chart 4)
The 2030 chart shows a more balanced population distribution in the 20-to-50 year segment for emerging markets than developed markets, which show a ‚Äúbulge‚ÄĚ in the middle that will gradually progress to the higher age brackets. Emerging markets may have demographics issues to address in the future, but those are in the more distant future than those looming for many developed nations.
Emerging market countries have higher growth expectations and lower debt burdens. That does not, however, assure that they will generate better returns in coming years. What about valuations ‚Äď are these positive traits already baked in? The short answer is no. Current valuations remain attractive for emerging market equities relative to their 10-year and 20-year averages. (Chart 5)
The trailing price/earnings ratio (P/E) on the MSCI Emerging Markets Index was 11.6x as of September 16, 2012. This is a 15% discount to its 10-year average and a 27% discount to its 20- year average. This is especially attractive when combined with higher growth expectations that will increase the ‚ÄúE‚ÄĚ in the P/E ratio. (Chart 6)
Forward P/E is 10.14x as of September 16, 2012. This is a 4% discount compared to the 10-year average and 20% discount compared to the 20-year average. Additionally, forward earnings on the MSCI Emerging Markets Index are expected to grow at 11.7% over the next 12 months (as of June 30, 2012) compared to 8.9% for the MSCI World. (Chart 7)
Lastly, some complain that earnings in emerging markets are inflated by cost cutting, are unsustainable or misleading. However, the price/book ratio (P/B) also looks favorable. The P/B of the Index is 1.6x compared to a 10-year history of 1.99x and a 20-year history of 1.89x. This is a 20% discount compared to the 10-year and a 16% discount to the 20-year average P/B.
Based on these three valuation tools, emerging market equities look undervalued. If these ratios normalize, that could translate into a cumulative return in the range of 15% to 20%. The upside could be even higher when considering the lower government debt burdens, higher GDP growth forecasts, and higher earnings growth expectations. Investors may benefit from greater growth AND normalizing multiples, suggesting that this might be a favorable time to increase or initiate emerging market equity exposure.
Emerging market countries have lower annual deficits, much lower debt/GDP ratios and better forward growth expectations than developed markets. Additionally, valuations look attractive for investors. Emerging market equities do come with added risk due to higher political risk and greater volatility. However, now appears to be an attractive entry point for investors that should result in fair compensation for the added risk.
Historically emerging market equities have produced better risk-adjusted returns than developed markets. For example, the trailing 10-year Sharpe ratio for the MSCI Emerging Markets Index is +0.52 compared to +0.02 for MSCI EAFE Index. An investor‚Äôs individual ideal allocation is contingent on their risk/return objectives, but we encourage investors to incorporate meaningful emerging markets exposure in their non-U.S. allocation.
Past performance is no guarantee of future results. Any sectors, industries, or securities discussed should not be perceived as investment recommendations. The views expressed represent the opinions of Managers Investment Group and are not intended as a forecast or guarantee of future results. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for a long term, especially during periods of downturns in the market. Investments in emerging markets are subject to certain risks such as erratic earnings patterns, economic and political instability, changing exchange controls, limitations on repatriation of foreign capital, and changes in local governmental attitudes toward private investment, possibly
leading to nationalization or confiscation of investor assets.
The S&P 500 Index is capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The S&P 500 Index is proprietary data of Standard & Poor‚Äôs, a division of McGraw-Hill Companies, Inc. All rights reserved. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
The MSCI EAFE¬ģ Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The MSCI World IndexSM is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The MSCI World Index consisted of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States.
All MSCI data is provided ‚Äėas is‚Äô. The products described herein are not sponsored or endorsed and have not been reviewed or passed on by MSCI. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data or the products described herein. Copying or redistributing the MSCI data is strictly prohibited. The Indices are unmanaged, are not available for investment, and do not incur expenses. Investment advisory services are offered by Managers Investment Group LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Managers Investment Group LLC is a subsidiary of Affiliated Managers Group, Inc. (NYSE: AMG). Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed.
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