Should emerging market equities trade at a premium?
Emerging markets have faster growth, lower debts and better demographics than developed countries, so you might expect their equity markets to trade on a premium. They don’t.
Historically, investors have placed a higher multiple on developed markets – this may have been justified when developing countries seemed more likely to hit a crisis. Now that this has reversed shouldn’t these markets carry a higher valuation? As the chart below shows, developed markets have consistently traded at a higher multiple than emerging markets, apart from a brief period in the mid-nineties. In late 2007, expectations of a decoupling brought the two market valuations closer together – the severity of the subsequent downturn hit emerging markets hard but since then they have traded on a lower P/E ratio. So far this year emerging markets are off to a strong start, up more than 10%, but the valuation discount remains.
Could this just be due to a different sector breakdown? While some emerging countries do have lots of companies in some of the sectors that tend to carry lower valuations such as energy, financials or materials, at the aggregate level the weightings are fairly similar and a ‘sector adjusted’ P/E ratio shows the same overall pattern.
If we look within developed markets, those companies with emerging markets exposure do seem to be rewarded with higher valuations – this would suggest investors believe that emerging markets offer better prospects, but they aren’t translating this into action by purchasing stocks or bonds domiciled in these markets.
Why would this be? There are various explanations – worries over market transparency, rule of law and property rights all play a part. Perhaps the strongest argument why valuations aren’t higher is that despite all the positives, emerging markets have yet to show they have decoupled from developed markets.
In uncertain times, investors may prize factors like liquidity and stability more than they do exposure to growth. As the chart below shows, during recent sell-offs emerging markets have been especially hard hit, despite having little direct link to the troubles of the euro zone.
It may be that when we get to the point where developed markets are off life support and entering the less critical phase of rehabilitation (slower trend growth and deleveraging), emerging markets may secure the premium valuation they seem to deserve.
Re-published by permission from Scott Barber’s Blog on Reuters.com.
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