Are emerging markets stocks cheap?

Are emerging market (EM) stocks cheap by historical standards? The valuation gap between developed market (DM) and EM equities might suggest so.

The chart below shows that the valuation premium for DM stocks over EM peers is at its highest since June 30 2004, according to data from Unigestion, an investment management company. It measured valuations using price-to-book ratios, which are calculated by dividing a stock's price by the latest quarter's book value per share.

"The emerging markets are underperforming," said Bruno Taillardat, executive director at Unigestion. "What we are seeing is that there is a discount in EM valuations right now. It is such a big gap, we think it will converge."

Of course, it is not known how or when such a convergence - if it transpires - could take place. Indeed, if EMs are heading for the type of stress they experienced during the Asian crisis in 1997 and 1998, the divergence in valuations could yet gape wider.

The key question, therefore, is whether a fundamental analysis of EM economic trends justifies the relatively low EM equity valuations. As Alan Beattie noted on EM Squared, the International Monetary Fund (IMF) says that "secular" or trend growth has fallen across the developed markets from 2.25 per cent before the 2008/09 crisis to 1.6 per cent over the next five years, with an even sharper fall among EM countries.

Having risen in the decade before the crisis to 7.2 per cent per year, the trend growth in EM countries since 2008 has slipped to 6.5 per cent and is expected to drop over the next five years to 5.2 per cent, the IMF forecasts. Given this backdrop, the largely subpar performance of the MSCI EM index since the crisis appears more logical.

Potentially more telling than the softening trend are the reasons behind it. The IMF thinks the slowdown has resulted from a slippage in total factor productivity - the ratio of output to all inputs - which aims to capture the progress economies are making in ascending the value-added ladder. Those EMs that are failing to climb risk getting stuck in a "middle income trap".

The other big change since the crisis is that EM debt-to-GDP levels have soared, meaning that a higher proportion of corporate profits and household incomes is being spent on repaying borrowings rather than being recycled into technology and brand investments - or spent in shopping malls.

The debt numbers are stark. According to a study by McKinsey, total emerging market debt rose to $49tn at the end of 2013, accounting for 47 per cent of the growth in global debt since 2007. That is more than twice the EM share of debt growth between 2000 and 2007.

In addition to these fundamental concerns, a cluster of market risks damp EM investor sentiment. Concerns over a potential tightening in US monetary policy - notwithstanding the dovish outlook for Wednesday's Federal Open Market Committee (FOMC) meeting - continue to stalk those emerging markets that run considerable current account deficits and are therefore dependent on short-term portfolio inflows.

An environment of higher US rates is seen as likely to depress the values of EM currencies relative to the US dollar, thus making short-term portfolio investments in EM countries less attractive. The EM countries particularly vulnerable to this scenario are net commodity exporters that run significant current account deficits - Brazil, Indonesia, South Africa, Colombia, Ukraine, Peru, Chile and Argentina, according to Michael Power, strategist, Investec Asset Management.

Conversely, countries that run current account surpluses and are less reliant on commodity exports appear relatively insulated to US monetary tightening. China, Taiwan, Malaysia, Philippines, Vietnam, Bangladesh, Hungary, the Czech Republic and several Gulf states fall into this category.

So, one answer as to whether or not EM stocks are cheap is that the asset class encapsulates so many diverse realities that generalising across EM is less than helpful.

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