Global Markets

Valuations unlikely to continue to support EM equities

EM Valuations Monitor
Written by John Higgins

We think that the returns from emerging market (EM) equities in 2020 won’t be anywhere as good as in 2019. While this view is partly premised on our forecast that earnings growth will generally be weak, valuations are also unlikely to provide much support.

  • We think that the returns from emerging market (EM) equities in 2020 won’t be anywhere as good as in 2019. While this view is partly premised on our forecast that earnings growth will generally be weak, valuations are also unlikely to provide much support.
  • EM equities have generally risen rapidly since the fourth quarter of 2018, with the MSCI EM Index up by a bit more than 20%. Similar to developed market (DM) equities, this has been primarily due to a rise in their valuation. (See Chart 1.)
  • We don’t expect that pattern to continue for a couple of reasons. First, while lower interest rates have generally pushed up equity valuations since the global financial crisis, we think that the Fed is now done cutting rates. As such, we doubt that bond yields (at least in the US) will continue to fall and fuel another rise in equities. Second, even if the gap in valuations with DM equities is quite large, the valuations of EM equities are not unusually low.
  • Equities. The P/E ratio of the consumer discretionary sector is at a record high.
  • The valuations of dollar-denominated bonds generally appear quite stretched.
  • The currencies of Colombia and South Africa look overvalued.

Chart 1: Contributions From Earnings & P/E Ratio To Change In Of MSCI EM Index

Sources: Bloomberg, Capital Economics


Equities

  • The P/E ratios, using either trailing or forward earnings, of the MSCI EM Index have risen a long way in 2019 (2) and are now on the high-side of their historical range (3). That said, the valuation of the EM index is still far from its previous peak. It is also much lower than that of the MSCI World Index of developed market equities (4), although the gap in valuations is not unusually large.
  • At the country level, the picture is a bit more mixed. For example, the price/forward earnings ratios of MSCI’s Korea and Taiwan indices are more than 20% above their 5-year averages (5), notwithstanding those countries’ exposure to slower growth in China and US protectionism. Although valuations are not the main reason why we are more pessimistic about equities in EM Asia this year, they reinforce our view.
  • Meanwhile, on a sectoral basis, the P/E ratios of firms in the consumer discretionary and communications services sectors are more than 25% above their 5-year averages (6), and the former is at its highest-ever level (7). Since EM Asia equities have particularly heavy weightings in those sectors, this is another reason why we expect them to underperform eventually.

Chart 2: Price/Earnings Ratios Of MSCI EM Index

Chart 3: Historical Distribution Of MSCI EM P/E Ratios

Chart 4: Difference In Price/Earnings Ratios Between
MSCI EM Index And MSCI World Index (%)

Chart 5: Price/Forward Earnings Ratios Of MSCI Indices (Deviation From 5Y Avg., %)

Chart 6: MSCI EM Index Sectoral Price/Forward Earnings Ratios (Deviation From 5Y Avg., %)

Chart 7: Historical Distribution Of MSCI EM Consumer Discretionary Price/Forward Earnings Ratio

Sources: Bloomberg, CE

Equity Market1 Metrics

Equity Market1 Metrics

YTD Change

(%)

Price/12m Forward Earnings Ratio

12m Trailing Dividend Yield (%)

Current

Average2

Diff (%)

Current

Average2

Diff (%)

Argentina

-0.2

10.4

8.7

20.7

2.7

1.6

1.1

Brazil

-0.2

13.9

11.1

25.5

2.9

3.3

-0.4

Chile

7.3

14.9

14.5

2.5

3.6

2.9

0.7

China

3.3

12.2

10.5

15.7

1.9

2.4

-0.5

Colombia

-0.6

11.7

10.8

8.7

4.0

2.9

1.2

Czech Republic

0.2

11.7

13.6

-14.3

6.9

6.9

0.0

Egypt

0.0

9.3

9.0

3.5

1.8

1.8

0.0

Greece

-1.7

19.8

14.2

39.7

2.3

2.5

-0.2

Hungary

-2.0

10.0

10.0

-0.1

2.2

2.3

-0.1

India

0.9

17.8

15.9

11.8

1.3

1.4

-0.1

Indonesia

1.2

15.2

14.3

6.4

2.6

2.4

0.2

Korea

1.7

11.6

9.1

26.9

1.9

1.8

0.1

Malaysia

0.2

15.8

15.3

3.0

3.7

3.2

0.5

Mexico

2.8

14.0

15.0

-7.0

3.4

2.3

1.1

Pakistan

8.1

6.6

7.7

-14.3

6.1

6.1

0.1

Peru

-1.8

13.5

12.3

9.8

3.6

2.1

1.5

Philippines

-0.6

15.8

16.7

-5.3

1.6

1.7

-0.1

Poland

1.0

10.5

11.5

-8.8

3.2

2.8

0.4

Qatar

0.1

13.6

11.5

18.2

3.7

4.0

-0.3

Russia

2.7

6.7

5.8

17.1

7.0

5.2

1.8

Saudi Arabia

-0.8

16.8

15.8

6.1

3.8

0.5

3.3

South Africa

0.5

11.7

13.5

-13.6

3.1

2.9

0.2

Taiwan

1.3

16.4

12.9

26.6

3.7

3.8

-0.1

Thailand

0.1

15.7

13.7

14.6

3.0

3.0

0.0

Turkey

4.2

6.5

7.0

-7.5

3.5

3.4

0.1

UAE

0.2

8.2

8.8

-7.0

5.3

5.6

-0.3

Emerging Asia

2.0

13.4

11.4

17.9

2.2

2.4

-0.2

Emerging Europe

0.9

10.1

9.5

6.2

4.4

3.7

0.7

Latin America

0.8

13.8

12.4

11.8

3.1

2.9

0.2

Emerging Market Index

1.7

12.8

11.2

14.9

2.6

2.7

0.0

World (Dev. Market) Index

1.2

16.7

15.1

10.8

2.4

2.5

-0.1

Sources: Bloomberg, Capital Economics

Latest values are for 13th January 2020 unless otherwise noted.

1. MSCI Emerging Markets Indices (local currency).

2. 5-year average.


Bonds

  • Despite weak global economic growth last year, EM credit spreads have remained low. The credit spread of the JP Morgan EMBI Global – the benchmark sovereign dollar bond index – has dropped back to a level close to that of the ICE BofA EM Liquid Corporate Plus – the benchmark corporate dollar bond index (8). That has been mainly due to the fact that Venezuelan bonds have been phased out of the former.
  • Overall, the spreads of both sovereign and corporate EM dollar bonds are near the bottom of their historical ranges (9). Spreads are particularly low in Emerging Asia – both in absolute terms and relative to history. (10 & 11). But given our view that China’s economy will slow further, we suspect that the spreads will rise a bit over the coming months. Sovereign spreads in Africa are still above their post-crisis average, primarily because they are high in South Africa and Nigeria.
  • All this suggests that EM dollar bonds are generally quite highly valued, particularly those of the issuers that have the best ratings (12). While this is not an EM-specific phenomenon, the credit spreads of US corporate bonds have now returned to their early-2018 levels (13).

Chart 8: Credit Spreads Of EM Corporate & Sovereign Dollar Bond Indices (bp)

Chart 9: Credit Spreads Of EM Benchmark Dollar-Denominated Government & Corporate Indices (bp)

Chart 10: Stripped Spreads Of JP Morgan EMBI Global Indices By Region (bp)

Chart 11: Government Option-Adjusted Spreads (OAS) Of ICE BofA EM Corporate Plus Indices By Region (bp)

Chart 12: OAS Of ICE BofA EM Liquid Corporate Plus Indices By Credit Rating (bp)

Chart 13: OAS Of EM & US Corporate Indices
(bp)

Sources: Refinitiv, Bloomberg, ICE BofA ML, CE

Bond Market Metrics

Bond Market Metrics

Sovereign Rating1

Dollar Denominated2

Local Currency3

Foreign

currency

Local Currency

YTD Return (%)

Yield

Stripped Spread

YTD Return (%)

Yield
(%)

(%)

Current

Average4

Diff.

Argentina

CCC-

CCC-

-1.6

19.94

1820

758

1062

n/a

n/a

Brazil

BB-

BB-

1.0

4.09

211

254

-43

0.4

6.18

Chile

A+

AA-

0.7

3.47

140

150

-10

0.0

0.94

China

A+

A+

0.4

3.67

177

165

12

0.2

3.12

Colombia

BBB-

BBB

0.4

3.71

168

192

-24

1.2

5.75

Croatia

BBB-

BBB-

0.4

1.97

39

263

-224

n/a

n/a

Ecuador

B-

B-

-0.3

10.15

845

766

79

n/a

n/a

Egypt

B

B

0.4

6.56

461

431

30

n/a

n/a

Hungary

BBB

BBB

0.5

2.63

79

242

-163

0.1

1.17

India

BBB-

BBB-

0.4

2.92

122

168

-46

0.2

6.88

Indonesia

BBB

BBB

0.3

3.62

162

230

-68

0.9

7.01

Malaysia

A-

A

0.9

3.02

108

153

-45

0.4

3.30

Mexico

BBB+

A-

0.7

4.98

296

234

62

0.4

6.91

Nigeria

B

B

3.2

6.80

488

376

112

n/a

13.36

Panama

BBB+

BBB+

0.3

3.26

122

168

-46

n/a

n/a

Peru

BBB+

A-

0.7

3.14

112

165

-53

0.8

4.43

Philippines

BBB+

BBB+

0.3

2.67

74

136

-62

0.0

4.32

Poland

A-

A

0.3

1.85

23

115

-92

-0.5

2.01

Romania

BBB-

BBB-

0.7

3.57

155

202

-47

n/a

3.90

Russia

BBB-

BBB

-0.1

3.41

143

247

-104

0.8

5.99

South Africa

BB

BB+

0.8

5.17

321

256

65

0.2

9.52

Thailand

BBB+

A-

n/a

n/a

n/a

n/a

n/a

0.6

1.53

Turkey

B+

BB-

1.2

5.81

393

303

90

2.5

11.00

Ukraine

B

B

2.5

5.52

380

845

-465

n/a

n/a

Venezuela

SD

CCC-

-2.3

162.54

16098

2997

13101

n/a

n/a

Emerging Markets

0.4

4.78

283

349

-66

0.4

4.85

Emerging Asia

0.5

3.62

169

203

-34

0.3

4.31

Latin America

0.4

5.50

353

439

-86

0.5

6.00

Emerging Europe

0.8

4.37

247

291

-44

0.4

3.91

Middle East & Africa

1.2

6.36

445

381

64

0.2

9.52

Sources: Bloomberg, Refinitiv, Capital Economics

Latest values are for 10th January 2020 unless noted.

S&P long-term foreign-currency credit ratings. 2. J.P. Morgan EMBI Global Indices. 3. J.P. Morgan GBI-EM Broad indices. 4. 10-year averages.


Currencies

  • EM currencies generally strengthened against the dollar over the last quarter of 2019 (14), but for the most part the changes were small. When comparing EM currencies real effective exchange rates (REERs) to their long-run averages and trends, there is no sign of either widespread undervaluation or overvaluation, although a few countries’ currencies continue to stand out (15 & 16).
  • Argentina and Turkey remain the most notable outliers. While their REERs are far below their respective 5-year averages, that is because they were significantly overvalued until 2018. And their very high rates of inflation mean that the peso and the lira need to fall in nominal terms to keep their real exchange rates from appreciating. That said, both countries have reduced their current account deficits recently (18), which suggests that their fundamentals are at least improving.
  • Otherwise, we think that the currencies of Colombia and South Africa are a bit overvalued, partly because of the size of those countries’ current account deficits. In contrast, the deviation of the ruble from its 5-year REER average is mostly due to a rise in oil prices, which has boosted Russia’s terms of trade.

Chart 14: Equal-Weighted Index
Of EM Currencies Vs. US Dollar (Jan. 2017 = 100)

Chart 15: Real Effective Exchange Rate
(Deviations From 5Y Averages, %)

Chart 16: Real Effective Exchange Rate
(Deviations From 5Y Trends, %)

Chart 17: Inflation Differential With US
(pp, CE 2020 Forecasts)

Chart 18: Current Account Balances
(Change From Q1 2018 To Latest, pp Of GDP)

Chart 19: Current Account Balances
(% Of GDP, Latest)

Sources: Refinitiv, Bloomberg, CE

Currency Market Metrics

Exchange Rate Vs. US$

REER1

C/A Bal4

Current

Level

YTD

Change

Diff. From Average (%)2

Diff. From Trend
(%)3

% Of GDP

Argentina

59.7

-36.9

-61.4

7.7

-1.7

Brazil

4.1

-5.5

4.0

-0.3

-2.6

Chile

772

-10.0

3.2

-3.2

-3.6

China

6.9

-0.2

-4.5

-2.0

1.4

Colombia

3273

-0.6

-1.0

3.8

-4.5

Czech Republic

22.7

-0.9

4.9

0.5

0.5

Hungary

301

-6.7

-0.6

-1.1

-0.8

India

70.8

-1.3

-0.2

1.3

-1.5

Indonesia

13701

6.0

4.6

0.5

-2.9

Korea

1157

-3.6

-1.5

-1.1

3.8

Malaysia

4.1

2.2

-0.6

3.7

3.6

Mexico

18.8

4.8

6.1

6.7

-0.4

Peru

3.3

1.3

2.1

3.1

-1.7

Philippines

50.4

4.2

-5.9

10.7

-1.0

Poland

3.8

-1.3

1.0

0.1

-0.1

Romania

4.3

-5.3

0.9

0.5

-4.7

Russia

61.1

13.8

11.8

1.0

6.8

South Africa

14.4

0.0

6.7

1.2

-3.2

Thailand

30.2

7.6

6.8

3.2

6.3

Turkey

5.9

-9.9

-11.0

3.3

0.7

Sources: Bloomberg, Refinitiv, Capital Economics

Latest values are for 13th January 2020 unless noted.

1. Real Effective Exchange Rate Index.

2. REER relative to its average level of the past five years.

3. REER relative to the level now implied by the trend of the past five years.

4. Current account balance. The column shows the latest four quarter sum of the current account balance as a share of GDP


John Higgins, Chief Markets Economist, +44 20 7811 3912, john.higgins@capitaleconomics.com
Jonas Goltermann, Senior Markets Economist, +44 20 7808 4069, jonas.goltermann@capitaleconomics.com
Hubert de Barochez, Markets Economist, +44 20 7808 4088, hubert.debarochez@capitaleconomics.com
Simona Gambarini, Markets Economist, +44 20 7808 4076, simona.gambarini@capitaleconomics.com