Since the beginning of the year the emerging equity markets have gained 4 percent whereas the developed markets (generally known as the MSCI World index) have lost nearly 12 percent. Among the emerging markets, Asia has performed extremely well (+14 percent), whereas Latin America has lost nearly 16 percent and therefore was beaten by the MSCI World index. The loss of the Latin American emerging markets is mainly due to the Argentine crisis. In US dollar terms, the Argentine equity market lost 60 percent since the beginning of this year. This was entirely due to the massive devaluation of the Argentine peso versus the dollar.
Will emerging markets continue to perform better than developed markets in the coming months? Before we answer this question we give an overview of the characteristics of emerging markets.
The MSCI Index for emerging markets consists of four regional indices, whereas Asia has the biggest capitalization weight. Since 1988, the performance of emerging equity markets was around 11 percent p.a. compared to a performance of 7.3 percent p.a for developed equity markets. It has to be mentioned, however, that the risk in emerging markets is much higher than for developed markets.
But by adding a small amount of emerging market equities (around 5 percent) into a developed market portfolio, the risk is increased only marginally (by about 9 basis points), whereas the returns are increased by about 20 basis points.
Up to now we have discussed the long-term risk and return characteristics of emerging markets. These characteristics supply the arguments why emerging market equities should be included in the strategic asset allocation (benchmark). As we have announced recently, Clariden Bank includes emerging markets equities in the category alternative investments in the benchmarks of our balanced and growth investment profiles. But are emerging market equities attractive in the next six months?
As emerging market equities have outperformed developed markets equities since the beginning of this year, one might ask whether emerging markets now are just too expensive to buy. Measured by the price to earnings ratio (PER) based on estimated earnings for the next twelve months, emerging markets have become cheaper in the last three months. With a value of only 10, the current PER is more than one standard deviation below the historical average. Even if we take the PER of emerging markets relative to the PER of developed markets (the MSCI World has also become cheaper in recent months), emerging markets are priced below fair value.
At first sight, one might think that Asia should have become the most expensive region, as Asia outperformed the other emerging market regions since the beginning of the year. But taking into account that the (12 month forward) earnings per share (EPS) estimates for Asia were upgraded by 45 percent, whereas they were downgraded for the regions Europe & Middle East and Latin America by 8 percent each. Therefore, the PER in Asia has reduced more significantly since the beginning of the year than in Europe & Middle East and Latin America. It is true that the absolute PER in Asia is higher than in the two competing regions. But on average, the Asian markets were traded on a premium over the two other regions.
Emerging markets are cheap from a valuation point of view. But does this mean, that we can expect superior returns in the coming months? One common held view is that emerging markets are more cyclical than developed markets. From 1988 to 1995, the emerging markets were in investors’ fashion and outperformed the developed markets irrespectively of the phase in the business cycle. From 1995 to 1998 the emerging markets under performed. Until 1997 this can be explained with the slowing business cycle, afterward with the Asian crisis starting in summer 1997. Emerging market relative to Developed markets reached their low with the Russian and LTCM crisis in October 1998. Since then the emerging markets outperformed the developed markets hand in hand with the business cycle. We believe that the global recovery will continue from which emerging equity markets should profit.
The low valuation and the continuing economic upswing speak for investments in the emerging equity markets. Investors however, should be aware that investments in emerging markets are more risky than investments in developed markets as there is less transparency in accounting. But as the recent accounting scandals in the US have shown, even strict accounting standards are no guarantee against accounting fraud and bad corporate governance in general.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management.)
