Why emerging markets look attractive

The past three years have been marked by a slowdown in emerging market growth relative to that in the developed world but relative lead indicators for the emerging market economies have rebounded strongly over the past months (despite a temporary dip in February), with emerging market composite PMI new orders relative to those in the developed markets close to a three-year high. This is consistent with a rebound in relative IP (industrial production) momentum, which in turn would point to strong relative performance for emerging market equities.

As for what’s in the price, emerging markets are now trading at a 15% discount to global markets in terms of price/book (P/B), and this is below the trough point reached during the 2008 market panic and compares with a 10-year average discount of 2%. In terms of price/earnings, emerging markets are trading on a 23% discount relative to global markets.  This is an eight-year low and also below the long-run average. Depressed valuations in part reflect the economic slowdown, which for emerging markets largely reflects policy tightening in response to overheating pressures, which themselves were caused by excessive credit growth. Importantly, the slowdown in emerging market growth over the past three years has lowered overheating pressures and aggregate inflation has fallen from 7.3% to 4.9%, whilst aggregate emerging market wage growth has fallen from a peak to 19% three years ago to 11% today. The fall in inflation has also been aided by the recent correction in food prices, which are down by 20% from their April 2011 peak to a two-year low and food prices are particularly important, given that food accounts for around 30% of the CPI basket.  We can also note that the emerging markets are in aggregate still running a current account surplus, suggesting that they are not subject to structural overheating pressures (a growing current account deficit has been a tell-tale sign of unsustainable overheating periods in emerging markets in the past).

Relative margin weakness has been a problem in emerging markets, and while emerging market non-financial revenues have outpaced global non-financials, GEM non-financial net earnings growth has been negative with margins at a 10-year low, both in absolute terms and relative to global markets. The main driver of the margin compression has been rising unit labour costs, with wage growth running at almost 20% in emerging markets in 2010/11 during the most intense period of overheating pressures in these markets. While some of the increase in wage growth is structural, much is cyclical and wage growth rates have now eased, with bottom-up consensus numbers projecting the first increase in global emerging market non-financial earnings relative to their global peers since 2010 and a halt to the deterioration in relative margins.

Markets have also been affected by fund flows, and in the 12 months to end Q2 2012, emerging markets saw $150bn of capital outflows (or 0.6% of GDP), compared to capital inflows of around 5% of GDP in early 2011. This was mainly driven by outflows from China ahead of the leadership transition in late 2012. Since then, however, the flow picture has improved, with capital inflows positive again in Q4 2012 (the latest point for which we have data).

Looking forward, capital inflows into the emerging markets may be set to accelerate, as developed market central banks resume balance sheet expansion. Renewed expansion of developed market central bank balance sheets should push down developed world real bond yields, incentivising investors to focus on GEM currencies given that these currencies offer a higher real yield, and emerging market policy makers are likely to try to counteract the upward pressure on their currencies from capital inflows, resulting in an increase in money supply. Such increases in money supply tend to be associated with strong equity market performance.

Global emerging market equities also look cheap relative to comparable bonds, after significant decoupling with the relative price index of global emerging market equities recently close to a four-year low in US dollar terms, whilst emerging market bond spreads over US Treasuries fell to a three-year low in mid-February. Apart from the valuation case, emerging market corporates should benefit from the lower cost of capital that results from lower government bond yields.

Since end 2012 there has been strong outperformance by Japan’s equities relative to emerging markets, but once yen depreciation stops, any reflation in Japan should be positive for emerging markets. That said, in the short term a further fall in the yen would pressure earnings in emerging markets, suggesting that stock selection will be critical for adding value and controlling risks.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccl