Courage on the stock exchange is sometimes rewarded. EM equity investments made in October 1998 – the rock bottom of the Asian crisis – had increased sixfold by 2007. China’s integration into the world economy and the commodity boom in its wake had strongly boosted the stock exchanges of Brazil, Russia, India and China. Investors focusing on established markets had to live with a comparably meager return of roughly 100%.1
In mid-2010, the favorites changed. As measured by the MSCI Emerging Markets Index, EM investors could, at best, preserve their capital employed. Recent market adjustments have left the former EM star performers again far behind established markets. What’s next?
China’s economic growth is likely to stay well below the double-digit growth rates achieved in the past. Partly to blame is the shift from “Made in China” to ”Consumed in China“. This is also reflected in a reduced demand for raw materials, which in turn partly explains the significant decline in commodity prices. Since no reversal is in sight, commodity-exporting EM will continue to struggle.
Many companies in the emerging markets have used the low-rate policy of major central banks to finance growth via higher leverage. This increase is worrying and raises concerns about their vulnerability, when the Fed changes track. As measured by the ratio of net debt to earnings (EBITDA), EM corporations have been running higher debts than those in the industrialized world for roughly one year: Their debt ratio has increased sevenfold to 1.4 within eight years.
For 2016, analysts currently expect significant emerging-markets earnings growth of 11%. This seems over-optimistic, particularly the 25% for Latin America. However, after the most recent sell-off, EM equities are trading at a price-to-book (P/B) ratio of only 1.2. This valuation is in line with the crisis levels of 2001 and 2008 (see chart). The potential for further EM equity losses should thus be limited. We do not expect China to drag the world economy into recession. Downwards adjustments of earnings estimates in the U.S., European and Japanese markets, which have also suffered, should therefore be markedly lower than in the EM. Over the coming year, these developed markets may therefore offer a higher recovery potential.
Low price-to-book valuations should help limit future emerging-market-equities downside risk.
1 Performance as measured by the MSCI Emerging Markets Index and MSCI World Index, total return in U.S. dollars in the period from March 1999 to October 2007, Source: FactSet Research Systems, Inc.