Based on earnings expectations emerging markets equities are currently valued 27% below the price/earnings ratio of developed markets equities. The long term average of this discount is 19%. Closing the gap is a question whether the confidence of the markets in the earnings expectations is solid enough to facilitate a re-(e)valuation.
In the first four months of the year the emerging equity markets recorded the hoped-for increase, and with a plus of 14% a substantial one (year low to year high). From mid-February to the end of April they even outperformed the developed equity markets. In May, however, the situation changed, and the emerging markets fell behind again both in absolute and in relative terms. While the MSCI EM index is still on positive terrain at +5% in the year to date (in USD), this is largely due to three markets – China, Taiwan, and Russia – which together account for almost 40% of the emerging markets universe. Although at +24% Hungary has been clearly positive, it only commands a weighting of 0.2% and is thus only of marginal importance. The majority of the markets – almost two thirds – have been on negative terrain (in USD) in the year to date.
As far as the development from here on out is concerned, a number of factors are of relevance.
- the foreseeable US Fed funds rate hike will burden the equity markets at least for a short while (even though the long-term effects do not have to be negative). This will probably affect the emerging equity markets more significantly.
- if the Fed were to abstain from the expected hike this year, this would not help emerging markets equities either, because it would ultimately mean that the Fed expected the US economy to experience long-term stagnation.
- the overall index of the emerging markets has soared especially in China and Russia, but in both markets the upward potential should be limited after recent rallies.
- the positive growth gap of the emerging markets relative to the developed markets – one of the most important arguments in favour of investing in that segment – will fall to slightly above two percentage points in 2015, which from a long-term perspective is low. IMF forecasts predict a slight expansion for 2016, but the accuracy of said predictions has recently left a lot to be desired.
In terms of valuation, the picture is mixed. The PE-ratio on the basis of expected earnings (forward 12 months earnings expectations) is currently 27% below that of the developed markets; the long-term average of this discount is 19%. On the basis of historical earnings, the discount is roughly in line with its long-term average of 23%. The question is whether the confidence of the markets in the earnings expectations of the emerging markets is solid enough to facilitate a re-(e)valuation.
In summary, another equity rally would be surprising in view of the aforementioned factors.