Cheap Emerging Markets

Emerging Market Recovery Just Around the Corner

Performance of developed markets has been supported flow of liquidity as result of central bank response to anaemic economic growth. The byproduct of unstoppable quantitative easing is flow of money into stocks.

Stock markets in the Emerging Markets (EM) has been left behind. This is partly due to the investors realizing that the new normal of slower economic growth in developed markets ultimately means a flow through impact on the emerging markets.

Investors are asking the question, are emerging markets cheap due to cyclical slowdown or a change in secular trend. We are of the view that the recovery is just around the corner that now it is the time to load up on emerging market exposure. The most effective way of putting on a emerging market position is the through emerging market ETFs.

Overall the strong negative sentiment towards EM presents a contrarian play that ultimately can be very rewarding. We feel the risks are more than offset by the potential gain and we would load up in Emerging market stocks and bonds.

Emerging Markets Bonds

Developed Markets Interest Rates Emerging Markets Interest Rates

The low interest rate in developed markets and strong dollar presents a great opportunity for investors to sell overpriced US bonds and pick up cheap emerging market bonds.

Another high yield sector in the current environment is the high yield sector. However at this stage with continue uncertainty in oil prices, it presents a different incomparable set of risk profiles.

Those that are focused on imminent rise in rates should note that only because the fed lift rates from zero does not mean that they will continue to raise rates after. The strong dollar look to be pricing in a unrealistic scenario of a series of rate raises similar to post tech bubble recovery. This will not be a repeat of post tech bubble recovery where the fed raised rates 17 times consecutively.

Higher yields in emerging market bonds with already depreciated EM FX rates allows medium and long term investors a great entry point. Any global economic recovery and normalisation in rates would be matched by EM FX and rate recovery. Yields on emerging market bond ETFs with short to medium duration (3 – 5 years) looks rewarding to compensate for credit and FX risks.

 

Emerging Markets Equities

The weak performance of emerging markets has not helped by a strong dollar. Currently Emerging market stocks commonly Emerging Market ETF (VWO) is trading at p/e of 15. By buying VWO at this level investors has two primary tailwind in driving returns going forward.

Firstly with most EM currencies beaten down in anticipation of the Fed raising rates. Emerging market investors would be getting to the position with the FX movement in your favour. We feel that future easing in EM is largely priced in and current FX levels would provide sufficient unhedged return in the medium and long term.

Secondly the cheap valuation relative to developed markets with greater growth profile means a large margin of safety for equity investors. A broadly diversified emerging market stock ETF allows investors to protect against country or stock specific risk while rewarded for riding the secular trend in emerging market growth.

Emerging Market Forward PE

Source: JP Morgan Asset Management

Chart above shows the forward PE of the Emerging market index fund P/E vs the S&P 500 and MSCI Europe. It shows that on a relative basis EM is cheaper than developed market while historically due to better growth profile, EM trades at a premium to developed market. For medium and long term holders it looks it pays for taking the EM equity risk today.

EM Country PEEmerging market stock index on a segment basis shows there is distinct differences. India historically has been expensive and still is compared it is peers. In contrast while China is cheap on a relative basis at 10 times current p/e it is even higher on a forward basis. This implies market does not expect growth on a year on year basis.

Bottom fishing investors should note that Russia currently is the cheapest emerging market. However given continue weak commodity prices (to play the bounce see our best oil etf) and geopolitical risks in Ukraine. It is truely for the brave that can ride out the volatility.