TRANSCRIPT

Introduction

Welcome and thank you for watching "Ashmore's EM in 10," a short video designed to cover important events in Emerging Markets. I am Gustavo Medeiros, Deputy Head of Research at Ashmore.

As always, market participants are concerned about a number of topics:

Will US inflation really be transitory?
Are we getting more mobility restrictions due to the Delta variant of COVID-19?
What is happening with Chinese stocks?

On this video, we'll take a step back from all the usual market concerns, let's call it noise, and focus on equity valuations in Emerging Markets as well as in the EM vis-a-vis US stocks.

US stock valuations

Let us start looking at US stocks valuations.

On slide two you can see several high-profile investors and analysts have been calling US stock market valuations as excessive. In 2001, Warren Buffett said that the ratio of stock market capitalisation to nominal gross GDP was "probably the best single measure of where valuations stand at any moment." Back in 2001, this ratio peaked at 118% of the GDP, before the burst of the dot-com bubble.

Since 2010, market cap to GDP increased almost on a straight line, aside from modest corrections in 2011, 2015, 2018, reaching 179% of the GDP in the fourth quarter of 2019, before accelerating to the current 235% of GDP as of the first quarter of 2021.

The unprecedented increase began at the same time as the Fed started its quantitative easing policy. Low interest rates led to higher valuations across the board, including the stock market. Furthermore, since the bail-out of long-term capital management, the hedge fund, market participants became more confident that the Fed would not allow for any significant market correction without intervening. The so-called Greenspan-put turned into Bernanke, Yellen and now Powell-put. A Dupont analysis suggests market participants expect extraordinary profits ahead, which may not be sustainable.

On the next slide we can see US stocks are also expensive on a one-year trailing and one-year forward price-to-earnings basis with both ratios at higher levels than in 2001.

EM stock valuations

Now let us look at EM stocks and compare them with US stocks. In absolute terms, EM valuations look somewhat elevated with its market cap at 124% of GDP, mostly due to a strong bounce from 78% of GDP in the first quarter of 2020. The ratio is currently distorted by the deep GDP contraction in 2020, which depressed the denominator of the Buffet ratio, while rapid earnings expansion in 2021 pushed the numerator of the ratio higher.

Furthermore, EM GDP growth ex-China and ex-Taiwan has been running much lower than its potential for almost a decade now. Several factors suggest EM growth is likely to accelerate. Commodity prices are higher, supporting profits, supporting investment and consumption across EM exporters. The ongoing global economic recovery is keeping demand for tradable goods higher, supporting exports for consumer goods and manufacturing goods. Finally, the faster pace of vaccinations in EM will allow for a faster recovery in the service sector, which is yet to normalise. However, it is notable that the gap between EM and US stock markets valuation is the widest in 20 years at 111% of GDP as of the first quarter of 2021.

In price-to-earnings valuations terms, EM trades at 12.7 times earnings. At the same time, earnings per share is increasing at a fast pace. After considering the recent price correction in Asian markets, EM stocks price to earnings declined from 2.5 standard deviations above its five-year mean in January 2021 to only one standard deviation above its mean in July 2021, which is a meaningful derating.

Furthermore, at 12.7 times forward earnings, EM trades at almost half the level of US stocks which are trading at 21.7 times at 12-month forward earnings. This is the largest discount since the beginning of the chart, again, in 2005.

The contrast between EM and US stocks is even sharper in terms of 10-year trailing earnings compared to price. US stock prices are equivalent to 36 times the average of the last 10-years earnings while EM stocks trade at around 20 times. The 10-year trailing P/E was developed by Yale Professor Robert J. Shiller in order to adjust earnings for cyclical developments, which can temporarily distort the index.

Now that we know that EM equities are deeply undervalued compared to US equities, let's have a look at some EM-specific countries and discuss recent trends.

The Big Eight:

To get a more granular insight about specific markets, this section of the presentation examines the price/earn ratios and earnings per share across the largest eight EM countries within the MSCI EM index. We call them the Big Eight. Together, the Big Eight market account for nearly 88% of the MSCI EM as at the first quarter of 2021.

A quick analysis of the individual Z-scores of the Big Eight countries reveal a far more nuanced story across countries. India stands out as currently trading at two standard deviations above its mean. Valuations are more modest across other large Asian countries. South Korea is close to 1.0 standard deviation above its mean, while China and Taiwan are only around 0.5 standard deviation from their means after de-rating quite significantly from much higher levels since January 2020.

Russia's valuations recently declined to levels that are even more attractive, while Mexican price/earnings ratio currently sits below its 16-year mean. Brazil and South Africa are the cheapest in relative Z-score of P/E terms, at 1.6 and 1.4 standard deviations below their respective means.

Now let's look closer at the Big Eight countries on an individual basis.

Brazil

Brazilian stocks are currently very undervalued at close to eight-time earnings, or 1.6 standard deviations below its mean. Earnings are experiencing a sharp cyclical upswing, rising above 2013 levels for the first time, while its stocks still trade at a deep discount. Brazil's undervalued currency due to political uncertainties and high levels of government debt may be part of the explanation, but at current valuation levels stocks prices seems to discount those risks and perhaps even more.

South Africa

On the next slide we have a look at South African markets. South African earnings per share barely grow from 2008 to 2019. Much like South Africa's economy, its companies have been supported by strong institutions, but there has been not much improvement since the end of the Thabo Mbeki's administration. Higher commodity prices are boosting the outlook for earnings growth, which is expanding for the first time since 2008. Hence, the recent volatility of South African stocks caused by political unrests, alongside with cheap valuations in sectors, in some specific sectors, mean that there are attractive investment opportunities in the South African market in our review.

Russia

Russian stocks trade at only 6.9 times earnings, which is the lowest level of valuations across the Big Eight. Russia's earning has improved from 2016 to 2019 thanks to solid macroeconomic policies, including prudent fiscal policies and a highly credible central bank, which lead to a brief increase on PE ratios from very depressed levels. Today, earnings-per-share is rebounding due to a strong economic recovery and higher oil prices, which may well be extended over the next several quarters.

Mexico

On the next slide, let's look at Mexico. Mexican earnings per share, which is the blue line, are back to pre-COVID levels, but are still around their 16-year average. In our view, Mexican earnings growth is likely to expand further thanks to the economic rebound in the United States economy and the ongoing re-opening of the Mexican tourism sector. Mexican stocks currently screen as undervalued, particularly considering the current stage of economic cycle, at 13.9 times earnings.

China

Next, let's look at Chinese stocks and discuss a little bit of the recent developments. Earnings per share for Chinese stocks have hardly declined during the pandemic and have since returned to the same levels of the 2018 and 2019 period. Price to earnings rose from 11 times in September 2019 to 16.8 in January 2021, before declining to 12.9 times on the 27th of July, only 0.4 standard deviations above its mean. Most of the recent correction came from stocks in the technology sector, as well as real estate and educational sectors. All these sectors came under pressure due to increased regulatory pressure in specific industries, leading more recently to broad negative sentiment across Chinese stocks. We think that fears of state interventions on the broad economy are exaggerated, therefore most likely the current sell-off in Chinese equities is a buying opportunity.

Korea

On slide number 14 we can see the earnings profile from Korean equities. Korean earnings have also benefited from a strong rebound in demand for manufactured goods after the COVID-19 shock, which took place just after a strong downturn triggered by the US-China trade war in 2018. Korean stocks moved from undervalued 7.6 times earnings in October 2018, to 13.8 times earnings in December 2020. More recently, a sharp acceleration in earnings growth in excess of equity price increases led to a decline in the P/E ratio to 11.2 time earnings.

Taiwan

Next, let's talk about Taiwan stocks. Taiwanese stocks also benefited strongly from the COVID-19 crisis as higher demand for high-tech electronic goods created a shortage of semiconductors across the world. Taiwan's price to earnings ratio also accelerated from 12.4 times in October to 18.3 times in January 2021 before de-rating to 15.1 times as of the 27th of July 2021, most of the due rate came as a result of 57% surge in earnings between July 2020 and July 2021, as you can see by the blue line.

India

Lastly, let's have a look at India. Indian 12-month forward earnings estimates have seen a strong cyclical rebound, bringing earning per shares to its highest historical level. At first sight, Indian stocks valuations looks pricey at 22 times earnings. Indian stocks, however, historically traded at a premium due to distinct features of the Indian market that includes a domestic oriented economy, a very broad equity market with many opportunities across sectors, large ownership of stocks by domestic investors, which means a strong home bias, and finally, one of the strongest demographic profiles in the world. All of that led to a structurally solid increase in earnings growth, as you can see by the blue line on the chart.

Conclusion

This video analysed US and EM stock prices using two different methodologies: the so-called Buffett ratio, which compares market's cap to GDP, and the traditional price-to-earnings ratio. Both methodologies suggest EM stocks are meaningfully undervalued vis-a-vis US.

On an absolute basis, EM stocks do not look super cheap vis-a-vis its recent history, largely due to the recovery stage of the economic cycle, that we encounter ourselves. At this stage, valuations tend to lead earnings revisions but over the next quarters and years, higher earnings are likely to lead to a stronger rating.

The report also highlights significant valuation opportunities among EM countries, and hence for active managers.

Thank you for watching "Ashmore's EM in 10." Please do not hesitate to contact us should you have any questions or if you would you like to discuss any matters further. All the best!