Highlights

  • EM stocks are about one standard deviation above their fair value, according to several valuation indicators.
  • Provided EM equities are neither extremely overvalued nor undervalued, the key to their performance over the next 12 months will be corporate profits.
  • Having missed this rally, we are reluctant to chase it at current levels amid the prevailing investor euphoria and overbought conditions.
  • Compared with DM equities, EMs are not cheap - relative valuations are neutral. Meanwhile, the corporate profit outlook is better in DM than EM.
  • As a result, we are reiterating our underweight stance on EM stocks versus DM bourses.

Feature

This week we delve into overall emerging markets (EM) stock valuations. Next month we will publish another report outlining a valuation ranking among individual EM bourses and equity sectors.

After the significant share price run up, the question for investors is whether EM equities are still cheap or have become overvalued.

Our composite valuation indicator based on trimmed-mean multiples suggests that EM equity valuations are one standard deviation above their fair value (Chart I-1). The message is the same when using the medians of various multiples for 50 sub-sectors (Chart I-2).

Chart I-1
EM Equity Valuations:
Trimmed-Mean Multiples
Chart I-1

Fullscreen        Interactive Chart

Chart I-2
EM Equity Valuations:
Medians Of Multiples
Chart I-2

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These two composite valuation indicators are the averages of the trailing P/E, forward P/E, price-to-cash earnings,1 price-to-book value (PBV) and price-to-dividend ratios. The 20%-trimmed mean excludes the top 10% and bottom 10% of sub-sectors - i.e., it removes outliers and then calculates an equal-weighted average.

Finally, the composite valuation indicator using equal-weights (not market-cap weights) for all 11 sectors also corroborates that the overall EM universe is somewhat overvalued (Chart I-3).

Interestingly, based on Chart I-1 and I-2, EM stocks did not become cheap at their 2016 bottom - they were only fairly valued in early 2016.

The individual components of the composite median valuation indicator - based on medians of 50 EM sub-sectors - are presented in Chart I-4. The top three panels reveal that the trailing P/E, forward P/E and price-to-cash earnings ratios are all well above their historical mean, and close to their previous peaks.

The components that keep the composite indicator from being extremely overvalued are the PBV and price-to-dividend ratios. These two variables are close to their historical means (Chart I-4, bottom two panels).

Chart I-3
EM Equity Valuation:
Equal-Weighted Sector Multiples
Chart I-3

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Chart I-4
Components of Median
Valuation Composite
Chart I-4

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As to qualitative assessment of EM valuations, our sense is that EM equity segments that have good fundamentals are currently overvalued, while those that feature low multiples are "cheap" for a reason.

Bottom Line: According to valuation indicators based on various multiples, EM stocks are moderately overvalued.

Relative Valuations To DM

Relative to DM, EM equity valuations are neutral.

  • Both relative composite valuation indicators computed using 20% trimmed-mean and the median are at the middle of their historical range (Chart I-5). This signifies there is presently no valuation gap between EM and DM stocks.
  • All these measures are determined using the MSCI indexes, and utilize comparable data for both DM and EM across all companies, industry groups and sectors.
  • Using equal weighted-sector multiples, the EM versus DM relative composite valuation indicator also upholds that relative equity valuations are neutral (Chart I-6).
  • This measure uses equal weights for all sectors in both the EM and DM stock indexes. Hence, this composite removes sector weight differences among various equity indexes.
  • EM equity valuations are also on par with the U.S. stock market, based on 20% trimmed-mean, median or equal sector-weighted multiples (Chart I-7).

Chart I-5
EM Versus DM: Relative Trimmed-Mean
And Median Multiples
Chart I-5

Fullscreen        Interactive Chart

Chart I-6
EM Versus DM: Relative Equal-Weighted
Sector Multiples
Chart I-6

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Chart I-7
EM Versus U.S.: Trimmed-Mean, Median And
Equal-Weighted Sector Multiples
Chart I-7

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The takeaway from these relative valuation composites is that EM stocks are neither cheap nor expensive compared with U.S. or other DM equities. This is contrary to the widely held view among many investors and commentators that EM stocks are cheap versus DM in general, and the U.S. in particular.

Additionally, in absolute terms, EM, DM and U.S. equities are all - about one standard deviation - expensive, according to these valuation yardsticks.

Bottom Line: After removing outlier sub-sectors with the lowest and highest multiples and using equal weights for all sectors in the equity benchmarks, EM valuations appear comparable to those in the DM universe and the U.S.

The CAPE Ratio: A Structural Valuation Perspective

Our cyclically-adjusted P/E (CAPE) ratio for the EM equity universe currently stands at its fair value (Chart I-8).

Due to the lack of historical data for EM, we were unable to use Robert Shiller's methodology for constructing the CAPE ratio for developing markets. The Shiller method uses a 10-year moving average of EPS to calculate the cyclically adjusted EPS. However, in the case of EM aggregate EPS, data go back only to 1986. If we were to calculate a 10-year moving average, we would lose 10 years of data, and the valuation indicator would only start in 1994. This is too short a time frame for a structural valuation indicator.

Instead, we used the following methodology to construct the CAPE ratio:

  • We deflated EM EPS and EM equity prices (both in U.S. dollar terms) by U.S. consumer price inflation (CPI) to get both EM EPS and EM share prices in real (inflation-adjusted) U.S. dollar terms.
  • Then we regressed EM EPS in real U.S. dollar terms against a time trend. The resulting trend line represents the cyclically adjusted EPS in real U.S. dollar terms (Chart I-8, bottom panel).
  • Finally, we divided EM stock prices in real U.S. dollar terms by the EM EPS trend line. The outcome is the EM CAPE ratio (Chart I-8, top panel).

To be sure that our methodology produced a reasonable outcome, we computed a CAPE ratio using our methodology for the U.S. stock market and compared it with the Shiller CAPE ratio. Chart I-9 demonstrates that our methodology generated a CAPE ratio quite similar to Shiller's CAPE ratio from 1935 to the present. Consequently, we are comfortable that the results generated by our methodology are robust and sensible.

When we calculate the EM versus U.S. relative CAPE ratio, the outcome is that EM appears cheap versus the U.S. stock market (Chart I-10). The degree of relative undervaluation is meaningful: one standard deviation.

Chart I-8
EM CAPE Ratio Is At Fair Value
Chart I-8

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Chart I-9
U.S. CAPE Ratio: EMS Vs. Shiller
Chart I-9

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Chart I-10
Relative CAPE Ratio: EM Versus U.S.
Chart I-10

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The idea behind the CAPE model is to remove cyclicality of corporate profits when computing the P/E ratio. Our CAPE model gauges stock valuations under the assumption of EPS converging to their trend line. The latter is the cyclically adjusted EPS in real U.S. dollar terms.

The slope of the time trend - the historical annual compound growth rate of EPS in inflation-adjusted U.S. dollar terms - is 2.8% for EM and 2% for the U.S. Please note that we determined the earnings time trend using the historical range of 1983-present for EM and 1935-present for the U.S.

Hence, these CAPE models assume that EM EPS will grow 0.8% (2.8% - 2%) percentage points faster than U.S. corporate EPS in the inflation-adjusted U.S. dollar terms, as they have done historically. Under this assumption, EM stocks are materially cheaper than the U.S. market.

Finally, the CAPE ratio is a structural valuation model, i.e., it works in the long term. Only investors with a time horizon greater than 3-5 years should use CAPE in their investment decisions.

Bottom Line: According to our CAPE models, EM equities are fairly valued in absolute terms, but they are meaningfully cheaper than U.S. stocks.

What About Interest Rates And Profits

The above valuation measures did not incorporate one important variable: interest rates.

The current high equity valuations in both DM and EM would in some way be justified if both global bond yields and EM local interest rates held at current low levels.

Our bias is that U.S. bond yields will break out, dragging up other DM bond yields. DM government bond prices seem to be teetering on the edge of a technical breakdown (Chart I-11). The current robust growth in the U.S. and euro area justifies upward revisions to their interest rate expectations.

In turn, higher U.S. bond yields will put a floor under the U.S. dollar. We anticipate that most of the potential U.S. dollar rally will occur versus EM and commodities currencies, and less so against the euro and other European currencies.

Chart I-12 demonstrates that since January 2017, EM currencies have defied the rise in U.S. inflation-linked bond (TIPS) yields. We expect the negative correlation between EM currencies and U.S. TIPS yields - which existed from 2013 to 2017 - to re-establish itself.

Chart I-11
DM Bond Prices Are On Edge Of Breakdown
Chart I-11

Fullscreen        Interactive Chart

Chart I-12
EM Currencies And U.S. Real Yields
Chart I-12

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This will likely occur as the recently approved tax cuts buoy the U.S. economy. Meanwhile, in China, regulatory tightening on banking and shadow banking as well as liquidity tightening will weigh on mainland growth. A shift in relative China-U.S. growth dynamics in favor of the U.S. will likely lead to a setback in the value of EM exchange rates.

In turn, EM currency depreciation will produce higher local bond yields in a number of high-yielding developing markets (Chart I-13).

Overall, the odds favor rising DM bond yields in the coming months. This, along with a slowdown in China, will trigger a selloff in EM currencies. The latter will produce widening EM credit (sovereign and corporate) spreads and lead to higher EM domestic bond yields. Altogether, this warrants a de-rating of EM versus DM equity multiples.

On corporate profits, visible growth deceleration in China heralds a notable relapse in commodities prices and EM EPS growth. Our EM EPS model - based on narrow money (M1) growth - continues to flash red on the EM corporate profit outlook (Chart I-14).

Chart I-13
EM Currencies And Local Bond Yields
Chart I-13

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Chart I-14
EM EPS Is At Risk
Chart I-14

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Investment Conclusions

Chart I-15
Bottom-Up Analysts Are
Record Bullish On EM EPS
Chart I-15

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  • Equity valuations matter most when valuations are at an extreme - two standard deviations overvalued or undervalued. This is presently not the case for EM stocks.
  • Provided EM equities are neither extremely overvalued nor undervalued, the key to their performance over the next 12 months will be corporate profits. We expect EM corporate growth to downshift due to a slowdown in China and a setback in commodities prices.
  • EM is more leveraged to China than to the U.S. or Europe. Hence, robust growth in DM is not inconsistent with our negative view on EM currencies and stocks.
  • In the meantime, EM share prices continue to exhibit strong momentum. It is difficult to time a reversal amid such intense capital inflows. Nevertheless, from a big-picture perspective, such a stampede and the ensuing melt-up in stock prices typically precedes a major top.
  • Having missed this rally, we are reluctant to chase it at current levels amid the prevailing investor euphoria (Chart I-15) and overbought conditions.
  • Compared with DM equities, EMs are not cheap - relative valuations are neutral. Hence, there is no valuation justification to favor EM versus DM. Meanwhile, the corporate profit outlook is better in DM than in EM.
  • As a result, we are reiterating our underweight stance on EM versus DM stocks.

Arthur Budaghyan, Senior Vice President
Emerging Markets Strategy
arthurb@bcaresearch.com

Andrija Vesic, Research Assistant
andrijav@bcaresearch.com

  • 1 MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company.

Equity Recommendations

POSITIONS ALLOCATION INITIATION
DATE
RETURN IN US$
ON EM EQUITY BENCHMARK
SHORT EM/LONG U.S. STOCKSDEC 14/10130.5%
SHORT EM STOCKSMAY 24/11-10.1%
COUNTRY ALLOCATION
OVERWEIGHT
TAIWANOVERWEIGHTAUG 09/0716.3%
KOREA IT SECTOROVERWEIGHTJAN 27/10118.6%
CZECH REPUBLICOVERWEIGHTJUN 21/11-51.5%
HUNGARYOVERWEIGHTMAY 20/1564.7%
POLANDOVERWEIGHTAPR 06/16-2.0%
THAILANDOVERWEIGHTOCT 19/162.3%
RUSSIAOVERWEIGHTNOV 16/16-9.7%
CHILEOVERWEIGHTJAN 03/18-1.0%
INDIAOVERWEIGHTJAN 17/18-0.1%
UNDERWEIGHT
TURKEYUNDERWEIGHTMAR 13/1227.7%
BRAZILUNDERWEIGHTAUG 21/1252.7%
PERUUNDERWEIGHTSEP 02/15-24.3%
MALAYSIAUNDERWEIGHTOCT 21/1522.8%
SOUTH AFRICAUNDERWEIGHTAPR 05/15-5.8%
NEUTRAL
HONG KONG - DOMESTIC STOCKSNEUTRALMAR 30/10
SINGAPORENEUTRALSEP 09/15
MEXICONEUTRALFEB 10/16
COLOMBIANEUTRALMAY 04/16
PHILIPPINESNEUTRALMAY 11/16
KOREANEUTRALAUG 23/17
INDONESIANEUTRALAUG 23/17
CHINANEUTRALDEC 20/17
OTHER EQUITY RECOMMENDATIONS - RELATIVE TRADES
LONG EM TECH / SHORT EM MATERIALSFEB 23/10218.6%
SHORT CHINESE PROPERTY COMPANIES / LONG U.S. HOMEBUILDERSMAR 06/12147.5%
SHORT EM BANKS / LONG U.S. BANKSFEB 12/13106.2%
LONG CHINESE SMALL CAPS / SHORT EM SMALL CAPSNOV 20/13-3.0%
LONG RUSSIA / SHORT MALAYSIA STOCKSMAR 02/1658.1%
LONG CENTRAL EUROPE BANKS / SHORT EURO AREA BANKS STOCKSAPR 06/16-33.1%
LONG LARGE 5 STATE-OWNED CHINESE BANKS / SHORT SMALL AND MEDIUM SIZE CHINESE BANKSOCT 26/1626.6%
LONG INDIAN SOFTWARE / SHORT EM STOCKSDEC 21/16-15.5%
LONG SINGAPORE REAL ESTATE / SHORT HONG KONG REAL ESTATE STOCKSMAR 22/177.9%
LONG RUSSIAN ENERGY / SHORT GLOBAL ENERGY STOCKSMAR 29/177.4%
LONG EM STOCKS / LONG U.S. 30-YEAR TREASURIESAPR 10/17-26.8%
SHORT KOREAN / LONG JAPANESE STOCKSAPR 26/17-0.7%
LONG ARGENTINIAN BANKS / SHORT BRAZILIAN BANKS*OCT 31/1727.3%
LONG INDIAN BANKS / SHORT CHINESE BANKSJAN 17/180.2%
OTHER EQUITY RECOMMENDATIONS - ABSOLUTE TRADES
LONG EM EQUITY VOLATILITY (ETF: VXEEM)MAR 06/12-42.2%
SHORT SOUTH AFRICAN GENERAL RETAILERSAPR 23/13-0.9%
SHORT MALAYSIAN BANK STOCKSJUL 20/16-21.3%
SHORT TURKISH BANK STOCKSAPR 19/17-7.9%

NOTE: RETURNS RELATIVE TO BENCHMARK. MSCI WORLD FOR EQUITY RECOMMENDATIONS UNLESS OTHERWISE SPECIFIED

Fixed-Income, Credit And Currency Recommendations

POSITIONS INCEPTION
LEVEL
INITIATION
DATE
RETURN
TO DATE
STOPS
FIXED-INCOME
RECEIVE KOREAN 10-YEAR SWAP RATESMAY 24/11191 BPs
SHORT 5-YEAR INDONESIAN BONDS5.2%MAR 20/12-1.0%
RECEIVE INDIAN 1-YEAR/PAY 10-YEAR SWAP RATESJUL 06/1636 BPs
LONG POLAND AND HUNGARY 5-YEAR BONDS / SHORT SOUTH AFRICA AND TURKEY 5-YEAR BONDSJUL 27/169.0%
LONG 7-YEAR ARGENTINIAN BONDS15.7%JAN 16/17-8.0%
RECEIVE HUNGARIAN 1-YEAR/PAY 10-YEAR SWAP RATESJUN 21/17-29 BPs
RECEIVE SOUTH AFRICAN 1-YEAR/PAY 10-YEAR SWAP RATESJUN 28/178 BPs
RECEIVE POLISH 10-YEAR /PAY CZECH 10-YEAR SWAP RATESJUL 26/1745 BPs
RECEIVE BRAZILIAN 3-YEAR / PAY 1-YEAR SWAP RATESAUG 02/17-87 BPs
CREDIT MARKETS
LONG 5-YEAR CHINESE CDSJUN 07/11-26 BPs
SHORT SOUTH AFRICAN / LONG EM SOVEREIGN CREDITAPR 10/124.6%
SHORT BRAZILIAN / LONG EM SOVEREIGN CREDITMAY 15/1212.0%
LONG PHILIPPINES / SHORT TURKEY SOVEREIGN CREDITJUN 04/136.1%
LONG PERU / SHORT BRAZIL SOVEREIGN CREDITAUG 21/139.4%
LONG EMERGING ASIA INVESTMENT GRADE / SHORT HIGH YIELD CORPORATE BONDSFEB 11/15-14.2%
BUY SOUTH AFRICAN / SELL RUSSIAN 5-YEAR CDS PROTECTIONFEB 11/15348 BPs
SHORT PERUVIAN CORPORATE BONDS / LONG SOVEREIGN BONDSFEB 18/15-16.7%
LONG HUNGARY / SHORT EM SOVEREIGN CREDITMAR 04/15-6.9%
LONG 5-YEAR BRAZILIAN CDSJUL 08/15-116 BPs
LONG 5-YEAR MALAYSIAN CDSAUG 05/15-94 BPs
LONG ARGENTINA / SHORT VENEZUELA SOVEREIGN CREDITAUG 24/1631.9%
LONG ARGENTINA / SHORT BRAZIL SOVEREIGN CREDITSEP 07/160.3%
LONG RUSSIA AND CHILE / SHORT CHINA CORPORATE CREDITSEP 14/1616.1%
SHORT EM CORPORATE AND SOVEREIGN CREDIT / LONG U.S. INVESTMENT GRADE CORPORATE CREDITAUG 16/17-1.1%
CURRENCIES
SHORT BRL / LONG USD1.66 (USD/BRL)SEP 06/111.2%
SHORT IDR / LONG USD 9155 (USD/IDR)MAR 20/124.0%
SHORT CLP / LONG USD 478.9 (USD/CLP)NOV 06/126.3%
SHORT ZAR / LONG USD10.51 (USD/ZAR)JUL 23/14-7.8%
SHORT CNY (12-MONTH NDF) / LONG USD6.71 (USD/CNY)DEC 09/15-9.2%
SHORT MYR / LONG USD3.98 (USD/MYR)JUL 20/16-5.8%
LONG ARS / SHORT BRL 4.7 (BRL/ARS)SEP 07/16-3.9%
LONG CZK / SHORT EUR26.96 (EUR/CZK)SEP 28/165.8%
LONG PLN / SHORT HUF 71.37 (PLN/HUF)SEP 28/165.6%
LONG THB / SHORT KRW32.22 (THB/KRW)OCT 19/165.8%
LONG RUB / SHORT MYR 15.07 (MYR/RUB)NOV 16/167.4%
SHORT COP / LONG BASKET OF USD & RUBNOV 23/16-6.9%
LONG 3-MONTH USD/KRW VOLATILITY10.81%JAN 25/17
LONG RUBUSD / SHORT BRENTMAR 17/17-18.5%
SHORT TRY / LONG USD3.67 (USD/TRY)APR 19/171.4%
LONG PLN / SHORT IDR3497.64 (PLN/IDR)JUN 21/179.7%
LONG CLPUSD / SHORT COPPERSEP 06/17-0.5%

NOTE: PLEASE NOTE THAT ALL CURRENCY TRADE CALCULATIONS INCLUDE COST OF CARRY.