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Is the emerging market discount justified?

Is the emerging market discount justified?

The tide may have turned when it comes to investor sentiment around emerging markets, but the timing of when to re-enter the asset class remains up for question.

Emerging market equities reached an inflection point between mid-March and April when investors finally shook off the taper tantrum. After over four years of sustained underperformance, emerging equities finally started to outperform their developed peers. Outflows, which topped $35 billion (£20.98 billion) between January and mid-April, slowed to a trickle and then turned positive as the value players moved in.

But therein lies the crux of the timing problem. While emerging markets are certainly cheaper than developed, with the US and many other major indices trading at or around all-time highs, are they so heavily discounted for valid reasons?

Certainly the timing of investors’ move back into emerging market equities is in many ways counter-intuitive. Setting aside the value aspect for a moment, there is undoubtedly a degree of performance-chasing. Since the start of the year, the MSCI Emerging Markets index is up 6.95%, compared with a more modest 3.29% rise in the MSCI World index.

However, the revival of interest is also coming at a time of heightened geopolitical tension when investors would normally be expected to shift into risk-off mode.

‘Stocks have not completely followed the typical risk-off script. Gold, a classic safe haven asset, remains well below its spring highs, and certain defensive sectors – notably utilities, telecommunications and health care – have struggled this month,’ said BlackRock global chief investment strategist Russ Koesterich.

‘Meanwhile, a number of higher risk segments of the market, such as frontier markets and emerging market stocks in Asia, have performed relatively well.

‘Emerging Asia has not been immune from the selling, but it has been outperforming the broader market and continues to attract new flows.

‘This seeming disconnect between investor angst – evidenced by a sideways stock market, rising volatility and selling of high yield bonds – and a proclivity for more exotic markets can be reconciled fairly simply: investors have a newfound interest in value.’

Koesterich points to more positive localised macro factors at play in emerging Asia, with Narendra Modi’s landslide election win in the Indian election raising real hopes of progress and economic growth stabilising in China. But the key factor remains the fact that while the region’s stock markets are trading above the ‘bargain basement’ levels seen in 2008, they are now trading at a 30% discount to developed markets.

‘At a time when most of the major asset classes look somewhere between fully valued and expensive, investors are being forced to look further afield in search of value and yield,’ Koesterich said. ‘Put differently, in a world where most investments look expensive, reasonable is the new cheap.’ 

Emerging equities may be cheap in relative terms with scope for their discount to developed markets to narrow on the back of renewed inflows, but earnings growth looks unlikely to be the main driver of any rerating.

Indeed, Lisa Shallett, head of investment and portfolio strategies at Morgan Stanley Wealth Management, said the bank is underweight emerging equities, warning that the asset class is still beset by risk with valuations ‘rich’, whatever the disparity with prices in the developed world.

‘Emerging markets have surprised to the upside this year. We believe performance may be ahead of the fundamentals. We are concerned about rich valuations, high debt, vulnerability to rising US rates, misallocation of capital, dependence on Middle East oil and uninspiring macro fundamentals, which is why [we are] tactically underweight this asset class,’ she said.

‘We also reject the argument that emerging market equities are cheap on a price-to-earnings basis. The median company is up in price, while earnings have yet to rebound and forward earnings revisions are negative. This suggests to us that emerging market valuations are actually rich.’

The lack of earnings growth was highlighted earlier this month. Some 70% of emerging markets companies issued negative earnings per share guidance for the third quarter, with just 30% issuing positive guidance. Updates from US-listed companies has been mixed, with Intel warning that emerging market sales ‘remain challenging’, while Nike reported an uptick in ‘almost every territory and increased revenue in nearly every key category’.

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