Lately, many individual investors and asset allocators are asking, “Is this the right time to invest in emerging market equities or increase my allocation?” Value-oriented investors may look at the cheaper price-to-earnings multiples (P/Es) and come up with a resounding “Yes!” Momentum-oriented investors point to 2013’s dramatic underperformance and could reply, “Not yet.” In the context of a multi-asset portfolio, PIMCO research and secular views suggest that “Yes, a modest overweight to emerging market equities is, in fact, currently warranted for many investors.”
Most investors who are bullish on emerging market (EM) equities point to variants of a simple fact: Cyclically adjusted P/Es (CAPEs) are significantly lower for EM equities versus developed market (DM) equities (see Figure 1).
Differentials in yield, valuation and risk: a look under the hood
Inverting these numbers implies an earnings yield of approximately 5% for DM equities and approximately 8% for EM equities. This is a good starting point for expected long-term returns (at least in local currency terms). But there are a lot of hidden details that should be considered before making an investment decision based solely on this one number. For example, we do not prefer EM bonds over DM just because EM bonds, on average, offer higher real (and nominal) yields than DM bonds (see Figure 2). We understand that this higher yield is partial compensation for higher credit risk, inflation risk and currency risk in EM bonds, as well as liquidity and confiscation risks. Similarly, the higher earnings yields in EM equities encompass many of these same factors, and just as we do with bonds, a deeper look under the hood is warranted to assess the true valuation differential.
One framework for isolating the relative attractiveness of each equity market is to compare the equity risk premium or ERP (see Figure 3), which is the incremental real yield earned by holding equities rather than local government bonds (equities earnings yields should be viewed as real rather than nominal). This essentially normalizes the differential in earnings yields for the higher real interest rates in the EM countries, which reduces what some analysts may perceive as a clear and significant advantage of EM equities over DM equities (see Figure 3). While the advantage in terms of earnings yields was almost 3%, the advantage in terms of the ERP declines to 2%.
It is important to understand what risk premium an EM equity investor is trying to harness relative to the DM equity opportunity cost. The ERP assessment in Figure 3 normalizes for differences in local interest rate levels and currency risk and therefore provides a better sense for the real valuation difference between these two markets. An investor could, of course, choose to leave the currency unhedged in order to earn the potentially higher government bond real yields if they feel they would be adequately compensated.
Finally, in order to obtain an even better apples-to-apples comparison, investors should account for the compositional differences in the sectors that constitute the two indexes. It turns out the EM equity indexes have a higher allocation to sectors that trade at lower multiples. While financials dominate both DM and EM indexes, they represent a larger proportion of the EM index (26.8%) than the DM index (20.8%). Healthcare represents 11.6% of the DM index while it represents only 1.7% of the EM index (per MSCI sector data as of 30 April 2014). The main exposure in EM financials comes from China, while the EM energy sector is focused in Russia. Both of these sectors trade at substantial discounts due to corporate governance issues. Also, Chinese banks trade particularly cheap due to the large amount of non-performing loans (NPLs) on their balance sheets. By aggregating sector-level CAPE using the sector weights of the MSCI World index, we can readjust the CAPE of the MSCI EM index (see Figure 4) and find that while EM equities remain cheap relative to DM equities, they are not as cheap as they looked at first blush.
Top-down perspectives inform the comparison
In order to come up with an investment decision in terms of both direction (overweight or underweight) and size (how much overweight or how much underweight), investors must then consider where these multiples and risk premiums are today relative to their history, as well as the current and projected economic backdrop: growth and inflation expectations, central bank policy actions and political and corporate governance changes.
The CAPE in emerging market equities is relatively attractive at the 13th percentile relative to 10-year history (see Figure 5), as is the ERP at the 79th percentile. That is, the CAPE is relatively low compared with its history, while the ERP is relatively high. The conclusion one could draw from this (before considering the macroeconomic backdrop) is that EM equities are slightly cheap relative to DM equities, but extremely cheap relative to their own history. Moreover, we believe that DM equities, while richer, are not in bubble territory as some analysts claim (although there is some truth to the assertion that DM equities would look richer if it was not for share buybacks and other financial engineering).
It is important to consider the macroeconomic backdrop when determining our final investment conclusions. The recently concluded PIMCO Secular Forum provided two important points to consider here.
The first is that global growth differentials are slowing. Although EM will continue to grow faster than DM, we believe the difference may be lower than what has been seen over the last five years: 5.3% real growth for EM versus 0.8% for advanced economies (Source: IMF World Economic Outlook Database as of 16 May 2014). For example, we expect China to grow at a pace slower than the 7.5% that the government is targeting; over the next few years we believe 6%–6.5% real growth is more likely, versus the 8.9% growth average over the last five years (according to the IMF as of 16 May 2014). This smaller growth differential between EM and DM economies implies (all else equal) that the earnings growth differentials should be smaller and hence the differences between equity multiples should be wider than they have been in the past. We believe this fundamental factor is largely responsible for the relative cheapness in EM equities, and – crucially – it is already reflected in the price.
The second all-important factor coming from the Forum is what we call the New Neutral, which is our expectation that the neutral policy rate at the Fed and other major central banks will be lower than what the market expects. At the Fed in particular, we think the neutral real rate could be closer to 0% than the 2% that the Fed has indicated. What this means (again, all else equal) is that for a given level of growth, the discount rate is lower and hence equity valuations should be sustainably higher over the secular New Neutral horizon. In addition, if the Fed does pursue a “lower for longer” approach on the policy rate, this should support positive returns from yield- and carry-oriented strategies (a reversal of the taper tantrum of 2013). Therefore, we believe an unhedged allocation to EM equities (i.e., earn the higher ERP and the additional interest rate differential) should be considered.
Implications for asset allocation portfolios
To conclude, we find that after adjusting for government bond yield differences and the different sector weights, EM equity multiples still appear cheap to DM equities – although not by as large a factor as a naïve look at the published multiples would imply. Hence we feel a modest allocation to EM equities is warranted. This allocation is further supported by our expectation that the New Neutral fed funds rate is lower than what the market expects, which increases the attractiveness of higher-yielding EM assets (both stocks and bonds). PIMCO is expressing this view in the multi-asset portfolios that we manage on our clients’ behalf.