Emerging-market stocks are at bargain prices, but should you buy?
- Nicholas Spiro says the sharp sell-off in emerging markets has now created an opportunity for bargain hunters
- However, risks and vulnerabilities continue to weigh on sentiment, especially in China, where the yuan is down and capital outflow is growing
Following a brutal sell-off that pushed the MSCI’s benchmark Emerging Markets Index down 25 per cent from its peak in late January, signs are emerging that developing-economy stocks are worth buying again.
First, the sharp decline in emerging market currencies came to a halt in mid-August. Since then, the MSCI Emerging Markets Currency Index, a gauge of 25 developing-country currencies versus the US dollar, has been fairly stable despite the renewed strength of the greenback since mid-September.
Second, there have been some encouraging developments in several important emerging markets. Buoyed by more credible policies to curb Turkey’s persistently high inflation, the lira has risen 16.3 per cent versus the dollar since early September, after a summer in free fall.
In Brazil, there has been a sharp rally in the currency and stock markets over the past few weeks. Jair Bolsonaro won the presidential election on Sunday, and investors seemed to have taken heart from his pledge to implement much-needed fiscal reforms.
Having said that, the overriding factor in the appeal of emerging-market equities is how cheap they have become since the beginning of the year. In contrast, American stocks remain expensive by most measures, despite having fallen steeply in October.
According to data from Bloomberg, the MSCI Emerging Markets Index has wiped out its gains from a rally that started in January 2016, in the aftermath of China’s surprise devaluation of the yuan. What is more, expectations for profits from emerging-market shares have shot up by nearly 40 per cent since then, allowing investors to buy the stocks at a price multiple similar to that in March 2016, when earnings were significantly lower.
A note from JPMorgan on October 22 – halfway through the latest phase of the sell-off in the US – throws the valuation of emerging-market stocks into sharper relief. According to the report, the MSCI Emerging Markets Index’s forward price-to-earnings ratio had fallen 17 per cent to 10.6 between January and October (and as much as 25 per cent for China, which accounts for 31 per cent of the gauge). This amounts to a 34 per cent discount against S&P 500’s current price multiple, the widest valuation gap since 2008.
Yet, valuations alone should not drive the decision on whether to pile back into emerging markets. The main reason why developing-economy stocks are comparatively cheap is the risks and vulnerabilities weighing on sentiment. Crucially, as China’s economy slows down, there have been acute tensions between Beijing’s deleveraging campaign and recent efforts to shore up growth and stem the rout in the equity market.
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Deleveraging has placed a huge strain on private companies, which are now at the sharp end of the stock sell-off. Falling prices also raise the spectre of a forced selling of shares held as collateral for loans. China’s conflicting policy objectives, along with growing capital outflows in response to the stealth devaluation of the yuan, make for a perilous trading environment.
Another reason why it is too soon to move back into emerging markets is that financial conditions are likely to tighten further in the coming months. The Federal Reserve is determined to keep raising interest rates despite plunges in stock markets and signs that growth is slowing, not just in China but also in the euro zone. Rising inflationary pressures in the US are widening the divergence in monetary policy. On Wednesday, the dollar index – a gauge of the greenback against a basket of other currencies – was at its highest since June 2017.
Moreover, markets remain volatile after the worst month for global stocks since 2012. The selling pressure has been fiercest on popular technology shares, the sector which propelled a US-led rally to a record high earlier in the year. The tech-heavy Nasdaq Composite index fell 9.2 per cent in October, its worst month since November 2008. Souring sentiment towards tech stocks is detrimental to emerging markets given the large weighting of Asian – in particular Chinese – tech firms in the benchmark index.
Although low valuations in developing economies create a buying opportunity some investors will find irresistible, emerging markets are relatively cheap for a reason. Bargain hunters would do well to bear this in mind.
Nicholas Spiro is a partner at Lauressa Advisory