Emerging market equities have delivered stellar returns over the last few years, outperforming their developed market peers since this new bull market began in end 2002.
As this continues, investors and asset allocators are questioning how long this can go on. The EM equity asset class now trades at a premium to the developed markets (on a trailing PE basis) for only the third time since 1990, and in each of the prior two episodes (1994, 1999) the markets corrected and moved back to a valuation discount.
Once the valuation correction set in, the EM asset class in both of the previous episodes moved from a valuation premium to a PE discount of 35-40 per cent to the developed market averages, and stayed there for years. Are we destined for a similar episode of valuation normalisation today? If so, investors buying into the EM asset class today are destined to suffer intense performance disappointment.
Investors are also concerned that at the beginning of this bull market, the EM asset class was trading at a 50% discount to the developed markets on PE multiples. The closing of this valuation gap has allowed the EM asset class to consistently outperform the developed markets and leverage its stronger earnings growth, but has now increased the risks of investing in the asset class.
If one looks at the fundamentals of the EM asset class, one sees why it has outperformed in this bull phase. In this cycle, the RoE of the GEM (global emerging markets) universe has been consistently higher than at the advanced markets, with the gap closing only this year. The GEM universe has also delivered a consistently higher rate of real earnings growth, 9.8 per cent versus 6.6 per cent for the world (source: UBS). Sustained higher earnings and RoEs have forced the markets to narrow the valuation discount. In addition to profitability, even the macro economic fundamentals of the EM universe have sharply improved. The GEM universe has moved from current account deficits of over 2% of GDP to running current account surpluses of over 3 per cent. The market cap weighted GEM credit rating has improved from BBB- in 1997 to nearly A- today.
With inflation and interest rates in the GEM universe converging with the levels in the west, the cost of equity of the GEM universe has also now come much closer to peers in the more advanced economies. As the cost of equity converges so should the valuation multiples. The volatility of the GEM equities has also fallen and inched closer to the levels of the more advanced markets.
Historically, the GEM markets had to deliver higher than expected returns to JUSTIFY the expected higher volatility, but as volatility levels have begun to converge, this valuation discount ascribed to the GEM universe is no longer justified. Even at a micro level the number of companies and percentage of MSCI EM market cap meeting international standards of transparency and corporate governance have never been higher.
The level of leverage has never been lower and in more and more industries the EM companies are now driving growth and innovation. Everyone is also aware of how the composition of global GDP will change with the top 16 EM countries accounting for 34 per cent of global GDP by 2017 (equal to the weight of the US and Japan: source: UBS). Already on an incremental basis, the EM countries are driving global growth and are the main reason why global growth decoupling is seen as the base case by most investors.
This seems to be a different era, and the fact that the EM universe has never traded at a valuation premium to the developed markets for a sustained period of time in the past does not mean it cannot do so going forward. Also even if multiples have converged on a trailing PE basis, EM equities still trade at a discount on forward earnings multiples.
One can question the comparability of the emerging market and world indices. Some investors make the point that if compared on an apple-to-apple basis, the EM asset class is not as expensive as it's made out to be looking at headline numbers. UBS has done an interesting study trying to account for the differences in the sectoral composition of the MSCI world and MSCI EM index.
The MSCI EM index has, for example, much higher weights in energy and materials (31 per cent compared to 17 per cent), and much lower weights in financials and healthcare (23 per cent compared to 33 per cent). When UBS compared sectors with equal weights in both GEM and the world indices to compare apple-to apple multiples, they found that the valuation gap had actually narrowed even more than apparent from looking at headline PE multiples.
So the valuation convergence is for real and has happened whichever way you cut the data. UBS went one step further and made more adjustments to account for industry group differences within sectors and also market capitalisations.
They found that at this more granular level, despite aggregate valuations appearing to have converged between global equities and the emerging markets at a specific industry level, GEM PEs still tend to be lower. Thus, at this level of detail while the valuation gap has certainly narrowed, there may still be some scope for convergence.
While the fundamentals of the EM universe have improved, there is a level of discomfort as the valuation cushion to justify continued outperformance of the asset class no longer exists.
Given the continued new highs posted on a daily basis, and the huge inflows into the asset class over the last few weeks, investors are clearly buying into the growth decoupling thesis. Also within the EM universe, the leadership continues to rest with the BRIC countries. From a sectoral perspective it is perfectly rational that domestically-oriented sectors are outperforming, as investors in search of growth visibility can justify premium valuations for superior domestic growth. More globally-oriented sectors have begun to underperform, and this trend is likely to continue.
All signs indicate that the EM asset class will continue to lead this bull market. But we are now entering uncharted territory from a relative valuation perspective. The asset class has never been able to sustain premium valuations in the past.
Could this time be different? Those are considered to be the most dangerous words in investing, but all signs seem to indicate that it is truly different this time. We will probably get a correction soon, given the pace and velocity of the rise experienced by most emerging markets, but that will most likely be seen as a buying opportunity. This story does not seem over just yet.