Developing countries such as Taiwan, China, Brazil and Poland are rising forces in the global economy.GREG BAKER/AFP/Getty Images
Emerging markets are having a moment. So far this year, they have produced returns that leave Wall Street in the shade.
Is this impressive performance just a blip? Skeptics will point out that emerging markets have generated mostly disappointing results over the past 15 years. That lacklustre history suggests we shouldn’t get excited about an upbeat few months.
Optimists, though, can argue that fundamentals are finally shifting in favour of up-and-coming economies. Their best-case scenario is that we are in for a rerun of the 2000 to 2010 period, when emerging markets boomed.
Many of the most respected global investment firms come down on the side of more restrained optimism. Consider the number crunchers at AQR Capital Management in Greenwich, Conn. They forecast that emerging-markets stocks will be the world’s top-performing asset class over the next five to 10 years, but only by a moderate margin. According to their models, emerging-markets equities are poised to deliver returns of about 5.8 per cent a year after inflation, which would be about a percentage point higher than stocks in the developed world.
This seems like a reasonable enough outlook. Developing countries such as China, Taiwan, Brazil and Poland are maturing, both in terms of technology and governance. No, they’re not perfect, and, no, they haven’t suddenly discovered any amazing new source of growth, but they are now rising forces in the global economy.
What makes them increasingly attractive right now is that large parts of the developed world are going in the opposite direction. The new case for investing in emerging markets is not so much about the huge potential of developing countries as it is about the dimming outlook for developed markets.
Tables have definitely turned. Twenty years ago, the world’s developed countries were more politically stable, more financially sound and more technologically advanced than emerging economies. None of that is true any more.
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Consider political stability. After Brexit and the second coming of Donald Trump, it’s no longer possible to maintain the illusion that developed nations are steadier and more predictable than their emerging counterparts. The political storms that swept through Britain and the United States over the past decade demonstrated that the world’s most venerable democracies can be just as giddy, just as chaotic, as anywhere else.
Government finances tell a similar tale. Public debt in developed countries such as the U.S., France and Japan has swelled to dangerous levels – much higher proportionally than in developing countries such as Chile, Colombia or Vietnam. Want to spotlight a government with out-of-control spending and deeply dysfunctional politics? Look at Washington, not Latin America or Asia.
As for technology, the developed world is falling behind in key areas of, well, development. It is the emerging markets of Taiwan and South Korea that dominate large areas of computer chip production. It is China, the biggest emerging market of them all, that leads the world in industries of the future such as solar power, batteries and electric cars.
All of this suggests that investors who write off emerging markets as too risky may be living in the past. On many counts, emerging markets look like steadier bets than Mr. Trump’s Fortress of Tariffs or the perpetually squabbling European Union.
Investors appear to be recognizing this. The iShares MSCI Emerging Markets ETF XEM-T produced a return of nearly 16 per cent (in U.S. dollar terms) over the past year.
The question now is whether emerging-markets stocks can continue to churn out similar returns. Their relative cheapness, even after their recent gains, suggests there still may be room to run.
One way to measure this cheapness is to look at what is known as the cyclically adjusted price-to-earnings ratio. The CAPE ratio compares the value of a country’s stocks to their average real earnings over the past decade. The lower the CAPE ratio, the cheaper the country’s equities.
To get a sense of how this works, start with U.S. stocks. They are now trading at a CAPE ratio of 42.1, according to Citigroup researchers. This is stratospherically high. It means that U.S. stocks are typically selling for more than 40 times their average earnings of the past 10 years, which is more than double the historical average CAPE ratio. Typically, such elevated levels signal a bubble; they suggest that disappointing returns lie ahead.
How about other markets? Canadian stocks are substantially less expensive than their U.S. rivals. They trade at a CAPE ratio of 26.8, according to Citigroup. British stocks are cheaper still, with a CAPE ratio of 18.1.
And emerging-markets stocks? There is a lot of variation between cheap markets like China and Brazil and expensive ones such as India. On average, though, emerging-market stocks sell for about 18.3 times their long-run earnings, which looks like a bargain compared to the developed world average of 33.7.
This suggests a strong case for edging into emerging markets, preferably through a broadly diversified emerging-market index fund, such as the ones offered by Vanguard Canada or iShares. The ride ahead may be bumpy, but in a world where developed markets are no longer a sure thing, investors have good reason to hedge their bets.