Our Historical and Current Perspective on Emerging-Markets Stocks
Our overarching belief that emerging markets’ macroeconomic fundamentals are much better now than they were during the crisis-prone years of the late 1990s/early 2000s has guided our views on the asset class over the past several years.
First, most emerging-market countries today have floating, rather than fixed exchange rates. This allows currency moves to release pressure that might develop due to fundamental imbalances. For example, if a country’s terms of trade are deteriorating (i.e., becoming less competitive), currency declines help correct that imbalance. Declines in currency also help fix the current account deficit problem. In the past, most emerging-market countries had fixed-exchange rates, so there was no pressure-release valve leading to larger imbalances in the economy and ultimately larger devaluation events.
Second, an economy’s dependence on foreign capital is a function of their current account deficit and their external debt burden, especially debt denominated in a foreign currency (typically in U.S. dollars). Today, the current account balance for most emerging-market countries has improved (see “Current Account Balances Have Largely Improved” chart to the right). External debt burdens in most emerging-market countries are lower today than in the mid- to late 1990s (see “External Debt Burdens Across Emerging- Market Regions” chart below on the right). Importantly, the risk of a U.S. dollar rise contaminating emerging-markets’ balance sheets is lower today than in the past as the proportion of emerging-markets sovereign debt in U.S. dollars has declined significantly since 2000 (per tradable debt figures from the Ashmore Group).
However, there are some countries where debt burdens have risen substantially, such as Korea, Brazil, China, and Turkey, and some of this increase is in the form of dollar-denominated corporate debt. But unlike the late 1990s, the vast majority of private-sector debt is in local currencies, not U.S. dollars (see “Foreign Currency Loans” chart below on the right). As a result, these countries’ external liabilities do not shoot up astronomically when their currencies decline versus the U.S. dollar. This is in contrast to the late 1990s, when the rapid rise in dollar liabilities forced emerging-market countries to spend their foreign exchange reserves to stem the currency declines, which made them vulnerable to further currency weakness.
It also forced them to raise interest rates sharply (to attract investors via higher yields and to counter inflation resulting from a weak currency) at a time when their economy was already slowing, leading to a much sharper economic downturn and recession. This belief that emerging markets are unlikely to suffer the sort of sustained crises they suffered in the late 1990s is an important factor why, after the recent price declines, we believe emerging-markets stocks have become sufficiently attractive to warrant a modest overweighting in our portfolios.
We first expressed our concern about the risks posed to emerging markets by China’s massive infrastructure spending and credit boom in 2011. This was the main reason we did not overweight emerging-markets stocks earlier.
As time progressed, this scenario started to gain more importance in our thinking as we started seeing signs of it playing out. We saw economists, buy-side portfolio managers, and sell-side analysts ratcheting down their China growth expectations. Even the Chinese government was guiding growth lower. Finally, we saw the Chinese government taking steps to rein in credit growth and curb speculation in the property market—which we considered an acknowledgement that this had been a problem.
We know that growth is slowing in China and emerging markets, so the next question is what reasonable normalized or trend earnings growth rate should we assume for emerging markets?
We use a 6% or so nominal earnings growth rate assumption for much of the developed world in our base case modeling. A 5% nominal growth rate for emerging markets over long periods seems reasonable and conservative in relative terms. Even in a slowing global world, where emerging-markets growth has also slowed, most emerging-market countries are still growing faster than the developed world (see chart below). This faster growth acts as a tailwind to sales growth over the long term, although we acknowledge not all of it flows through to the bottom line of emerging-markets stocks due to relatively poor corporate governance, greater shareholder dilution, etc. So, a 5% number passes the initial screen for reasonableness.
For context, we looked at a relatively longer earnings history of 20 years (this is the history available to us). The data showed emerging-markets stocks have actually compounded trend earnings at a 9%-10% rate in nominal terms over this time frame. We thought that almost halving the observed rate did a good job of discounting the over earning that might have taken place because China over the last 10 years. We also thought it properly accounted for the modeling risk stemming from making earnings-growth assumptions based on such short data history (20 years history is short in our opinion).
The next important assumption in our modeling is what P/E multiple to apply to our estimate of normalized earnings five years out (the product of the two gives us a price level five years in the future, which gives us the price return we can expect to which we add dividends to arrive at our total return estimate). We decided to stick with the 13x we originally applied in our old base case scenario for the following reasons:
It is slightly below the average and median P/E observed during the nearly 20-year emerging-markets history available to us.
It assumes an approximate 25% discount versus U.S. stocks (we apply a 17x P/E multiple to our normalized earnings estimate in our base case scenario for U.S. stocks). Historically, emerging-markets stocks have traded at an average and median discount of about 25%. (During the past two years, emerging-markets stocks have
traded at a discount of over 30% versus U.S. stocks, with the recent end-of-August reading showing a discount of nearly 40%, based on Bloomberg data.). This includes the 50%-plus discounts they traded at during the crisis periods of the late 1990s and early 2000s. As we stated earlier we think it’s unlikely for emerging markets to become that cheap again given the improvements we have seen fundamentally over the last 17 years.
Overall, the weight of the evidence suggests that emerging-markets stocks are cheap relative to U.S. stocks and at least as attractive as European stocks.
Jon Houk, CFP®