Emerging Markets: We think they’re worth the ride

At the start of the year, Russell’s strategists were clear on our expectations for the markets: we felt that stocks1 would continue to rise, cash2 would yield effectively nothing and that core bond strategies3 would post absolute returns of around 0%. By and large, so far, so good on those three calls, as of June 30, 2013.

We went on to say that within equities we felt emerging market stocks seemed poised to have a good run relative to developed market equities. A little more than halfway through the year, this has been dead bang wrong: the Russell Emerging Markets Index has returned -8.03% versus the Russell Developed Large Cap Index return of 8.71%. As my colleague Andrew Pease has said, “virtually everything that could go wrong for Emerging Markets did go wrong in the second quarter of 2013.”

The question we debated as we prepared the mid-year update to our 2013 Outlook is, “were we wrong, or were we right but early?”

Our conclusion: we believe that we are “right but early.” Here is why:

1. Relatively cheap valuations

When you look at the price-to-earnings ratio (P/E) of emerging market (EM) stocks, they are notably cheaper than their developed market counterparts. On a historical basis, that P/E relationship between EM equities and developed market equities isn’t so unusual. What is unusual, however, is how much cheaper EM equities are right now. As you can see in the chart below, the two lines are farther apart than they’ve been historically, making EM stocks appear relatively more attractive than developed market equities.

Trailing 12 Month PE Ratios

Source: Factset, I/B/E/S Consensus. Developed Markets Equity is based on the MSCI World Index. Emerging Markets Equity is based on MSCI Emerging Markets Index.

2. Attractive earnings estimates

A reasonable question to ask is, “Are EM stocks a value trap? That is, are they cheaper now for a (bad) reason that will become clearer in the future – for instance because the market is anticipating a collapse in EM earnings growth, economic growth, or both?”

Let’s look at each in turn to assess how realistic this might be right now.

As you can see from the chart below, earnings estimates for emerging market equities (and developed equities) look to be heading in a favorable direction: increasing.

Earnings per Share Year on Year Growth, %If EM earnings actually do grow and the stock prices of those companies do not go up because the market still doesn’t believe their value should appreciate, then the stocks will appear even cheaper on a P/E basis.

Forward 12 Month PE Ratios

Source: Factset, I/B/E/S Consensus. Developed Markets Equity is based on the MSCI World Index. Emerging Markets Equity is based on MSCI Emerging Markets Index.

Even after all the negative news that has hit EM recently, many analysts still see strong growth potential for both EM and developed market equities. Why?

3. Expectations for continued global economic growth

We think it is because, like us, they expect global economic growth will improve in the second half of this year. Indeed, we believe that economic growth in Japan, the European Union and the U.S. – which collectively represent 55% of the global economy4 and are the biggest customers for many listed EM companies – will be better in the second half of 2013 than it was in the first half. This matters for EM stocks because they have historically been more sensitive to global economic growth rates than Developed stocks. When growth rates have improved, earnings of EM stocks have typically grown at a faster rate than their Developed counterparts. Of course history doesn’t repeat itself, but it does often rhyme.

Source: International Monetary Fund, World Economic Outlook (April 2013). Developed Markets Equity is based on the MSCI World Index. Emerging Markets Equity is based on MSCI Emerging Markets Index.

Source: International Monetary Fund, World Economic Outlook (April 2013). Developed Markets Equity is based on the MSCI World Index. Emerging Markets Equity is based on MSCI Emerging Markets Index.

So, why are EM stock prices not currently higher?

The likely answer, in our view, is: uncertainty around whether or not what the market thinks will happen, will actually pan out. That is, recent events have caused the markets to more heavily weight the possibility the Chinese economy will have a hard landing, that political pressures will swallow Brazil, Turkey and Egypt and the result will be very bad for emerging markets as a whole.

Those possibilities are all too real, but in our mind, they’re not probable. But if the last four years have taught us anything, it should be that investing in probabilities and not in possibilities is the way to investment success. We diversify our investments because we know unexpected bad things happen.

The bottom line

Create context for your clients

In order to expect a rate of return, you must expose yourself to the risk that unlikely bad possibilities will happen. Diversification, though it doesn’t protect against loss, allows us to exploit the probable and contain the damage of the unlikely possibility. For most investors, we believe emerging market exposure should be a significant, but on the whole relatively small, part of a total portfolio. Over the last decade investors have benefitted greatly from exposure to these markets and we think they will benefit from it in the next decade. But it is going to be a bumpy ride.

Abraham Robison, an investment strategy analyst for Russell Investments, contributed to this post.

1Represented by the Russell 1000 Index, which has had a return of 13.91% YTD as of 6/30/13

2Represented by the Merrill Lynch U.S. Treasuries 1-3 Year Index, which had a return of 0% YTD as of 6/30/13

3Represented by the Barclays U.S. Aggregate Bond Index, which has had a return of -2.4% YTD as of 6/30/13

4Source: International Monetary Fund, World Economic Outlook Database, April 2013

The Russell 1000® Index is an index of 1000 issues representative of the U.S. large capitalization securities market.

The Barclays U.S. Aggregate Bond Index is an index, with income reinvested, generally representative of intermediate-term government bonds, investment-grade corporate debt securities and mortgage-backed securities.

The Merrill Lynch US Treasuries 1-3 Year Index is an index representative of coupon-bearing U.S. Treasury debt with terms to maturity of at least one year. Source: Merrill Lynch, used with permission. Merrill Lynch is licensing the Merrill Lynch Indices “as is”, makes no warranties regarding same, does not guarantee the quality, accuracy, and/or completeness of the Merrill Lynch Indices or any data included therein or derived therefrom, and assumes no liability in connection with their use.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

Forecasting or other forward-looking information is inherently uncertain and may be incorrect. Different time periods will produce different results.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

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