November 2011

INSIDE VIEW: Are emerging market equities currently overvalued?

­Emerging-marketsThe 'great recession' has enhanced the case for investing in emerging economies, say George R Hogue and Solomon Tadesse of State Street.

Emerging market equities and, particularly, currencies have sold off sharply in the past two months as Europe’s sovereign debt crisis has intensified. There is plenty to worry about: a double dip recession in the United States and Europe; a potential default in Greece; a banking bust in China, and a dysfunctional budget process in the US, to name a few. The risk of recession in the big economies is growing. In the event of sharp recession in the US, output and corporate earnings in many emerging markets will fall sharply. And obviously a disorderly debt default in the eurozone will spook all equity assets.

But given that emerging market equities have outperformed developed market equities by roughly 12% a year in dollar terms during this past decade ending in June, it is hardly surprising that global institutional investors are increasingly attracted to this asset class. (Flows year to date out of emerging markets mutual funds are roughly $36 billion (€26 billion), but last year they were $96 billion.) It is also not surprising that investors are asking whether emerging market equities are currently overvalued and can absorb large inflows.

Initial market valuations are of critical importance in determining long-term equity returns and in avoiding overpaying for growth. Right now, emerging market equities sell at about 8.5 times twelve-month forward earnings. The International Monetary Fund  points out in its Global Financial Stability Report that a one percentage point shift of global equity and debt securities held by the developed world’s institutional investors would result in inflows into emerging markets of roughly $485 billion. Moreover, Goldman Sachs and the Bank of England suggest that developed market investors are at least 50% underweight emerging market equities relative to a neutral weighting (approximately 13%) in the MSCI All Country World Index.

If developed market investors were to reduce their 6% to 7% underweight to emerging market equities over the next ten years, as a very rough estimate, potential inflows could exceed $200 billion a year, which is more than double the $95 billion in net portfolio flows into emerging market equities in 2010 – the largest on record. Assuming no disorderly defaults in the eurozone, we believe that emerging market equities represent fair value at current levels, and that long-term investors should consider taking advantage of current valuation levels to further reduce their home bias.

The recent “great recession” has enhanced the case for investing in emerging economies. First, the difference in economic growth rates between the emerging and developed worlds (currently about 2.5 times) is likely to be maintained and may even increase, especially since the developed world faces a prolonged period of fiscal adjustment and deleveraging.

Second, while the dynamic in each country varies, many emerging market countries are not highly indebted either at the sovereign or consumer level and enjoy substantial policy flexibility should another shock hit the world economy.

Finally, while emerging market banks will obviously be impacted by the new global banking regulation, in many cases their balance sheets and profitability are superior to those of their developed market counterparts.

Emerging market equities’ current valuation: ample margin of safety for investors
Have emerging market equity prices already been bid up to unreasonable levels? We address this question from various valuation perspectives.

Cost of equity: We assume that global investors determine their required return to reflect the US Treasury ten-year rate, a country credit risk premium and an equity risk premium over emerging market bonds. Emerging market credit spreads, as proxied by the JP Morgan EMBI+ Index during the Asia crisis, exceeded more than 1,000 basis points over Treasuries. But as of 30 September, 2011, they stood at roughly 420 basis points, for a nominal yield of roughly 6.27%. This bond yield can serve as a rough proxy for the risk free rate plus an emerging market sovereign risk premium.

The World Bank points out that some emerging market borrowers pay lower interest rates on their sovereign debt than several European countries. We believe that emerging market credit spreads will fluctuate but are likely to remain well anchored.

Equity risk premium to bonds (ERPB): This clearly varies over time. From 1900 through 2009, Dimson, Marsh and Staunton estimate in their Credit Suisse Global Investment Returns Yearbook that the average ERPB on global equities was about 3.7%. Combining this with the current estimated emerging markets beta to the MSCI World Index of about 1.2 provides an indicative emerging markets’ ERPB of roughly 4.4%. To be conservative, and because the beta of emerging markets can rise during periods of financial stress, we add an additional 1% to the ERPB. Thus, adding all the terms together, we estimate the current emerging markets cost of equity to be roughly 11.7%.

Growth rate: Growth in real profits in the very long term is closely related to real GDP growth. It is likely that real earnings per share and dividend growth in emerging markets over the next ten years will exceed that of the US market, where the geometric mean long-term growth rate in real dividends per share since 1950 has been roughly 1.3%.

Return on equity (ROE): Since 2001, ROE in emerging markets, a key determinant of profit growth rates, has exceeded developed market ROE. Over the past three years, emerging markets’ ROE has averaged 14.3%. Expected ROE in the emerging markets in 2011 is forecasted to be 15.3% versus 12.2% in the developed markets, according to Morgan Stanley and JP Morgan estimates. We believe that the MSCI Emerging Markets ROE will continue to exceed the MSCI World ROE.

Payout ratio: The five-year average payout ratio in emerging markets of 35% is below that of the developed markets’ 43%, according to Morgan Stanley estimates. This suggests higher long-term earnings and dividend growth rates.

Based on analysts’ long-term expected earnings growth, the chart below plots through time the ratio of the emerging markets price/earnings-to-growth (PEG) ratio to the developed markets’ PEG ratio.

Emerging markets sell at a 50% discount to developed markets by this metric. Investors are not willing to value earnings growth in emerging markets as fully as in developed markets. Possible explanations for this include: concerns over emerging markets political risk, high risk aversion among investors in general, and lower estimates than analysts estimated for long-term growth rates.

With these caveats in mind, the enormous discount could alternatively serve as a rough indicator of the potential absorptive capacity of the emerging markets. Of course, the situation varies significantly by country.

Careful attention
Flows into emerging market equities historically have been highly cyclical, and this phenomenon will likely persist, especially if the world’s two biggest countries fall back into recession. However, the disruption caused by the ‘great recession’ in developed markets is likely to accelerate secular flows to emerging market equities. This process is in its early phases and has not yet led to a bubble in emerging market equities. Gradual shifts in asset allocations may push up the equilibrium emerging market price/earnings ratio and lead to stretched valuations in some markets. Equity issuance in Brazil, Russia, India and China, particularly, in China, has the potential to accommodate increasing developed market flows to emerging markets. But investors should pay careful attention both to valuation levels at entry point and to the phenomenon of new issuance potentially diluting long-term returns.

George R Hoguet, global investment strategist, and Solomon Tadesse, senior quantitative research analyst, Advanced Research Center, State Street Global Advisors

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