The Emerging Markets Hat Trick: Time to Throw Your Hat In?
- Long-term investors have a unique investing opportunity in emerging market assets given the very rare combination of cheap equity valuations, depressed currencies, and positive momentum in equity prices and economic fundamentals.
- Even after the strong rebounds in emerging market assets since January 2016, which ended prolonged bear markets across the asset class, expected real returns over the next decade are still very attractive.
On the rare occasion when a hockey player scores three goals in a single game, fans throw their hats into the rink to acknowledge the feat, called a “hat trick.” The term originated over 150 years ago on the cricket pitch in the United Kingdom: the bowler who retired three batsmen with three consecutive balls was awarded a new hat. Today’s sports fans have evolved the practice into literally pummeling the goal maker with hundreds of hats. What has not evolved, however, is the rarity of the achievement.
Just as the unusual occurrence of three goals triggers the throwing of hats into the hockey rink, today’s similarly rare combination of exceptional valuation levels, depressed currencies, and powerful momentum—both price and economic—should encourage long-term investors to “throw their hats” into the emerging markets rink.
We emphasize long-term investor because it’s impossible to possess the clairvoyance to perfectly time the markets. Most of the volatility in shorter-term price changes is unpredictable noise. By contrast, long-term returns are mostly a function of yield, plus growth, both of which can be estimated with increasing accuracy as we look further into the future. Accordingly, at Research Affiliates we focus on gauging which assets and currencies are priced to deliver attractive returns over longer horizons, all while using shorter-term price and economic momentum as a barometer for the conviction in our expectations of future returns. Let’s dig a little deeper.
The investment community seems largely unaware of just how cheap emerging market (EM) assets have become as a result of a multi-year bear market that appears to have ended in early 2016. In January 2016, we characterized EM equities as “the trade of the decade.” The January lows were by all accounts exceptionally low. As far back as we have good data, we find only 24 non-overlapping instances—after screening 24 developed and emerging market countries—in which the Shiller P/E of a country’s equity market dipped below 10.0x. Even rarer is the Shiller P/E of an entire region dipping below 10.0x.
Driven by extremely cheap (and likely well-deserved) valuations in Brazil, Russia, Poland, and Turkey, the Shiller P/E of the MSCI Emerging Markets Index dipped below 10.0x in January for the first time since the index’s inception, settling just shy of that low at 9.6x to close out the month. With a 19% rebound since then, some investors might think they’ve missed the rally and it’s now too late to invest. They may want to reconsider.
The recent rebound in EM equities from February through November 2016 is tracking the average experience, and if history is any guide, the path of least resistance indicates more upside to come. The asset class may not deliver the additional 100% return over the next four years consistent with the average historical experience, but it’s by no means impossible. Even after this year’s rally, EM equities are trading at a depressed Shiller P/E of 11.2x, still well below the 13.0x observed during the darkest days of the 2008 global financial crisis.
Although EM currencies, represented by the JPMorgan Emerging Local Markets Index Plus, have rebounded since January 2016, they continue to trade near the discounts associated with the 1997 “Asian Contagion” and 1998 Russian debt default. EM currencies can certainly get cheaper before they revert toward historical norms, but they might just as easily snap back quickly to fair value. Our relative PPP reversion expectations with high EM cash rates, a faster growing working-age population, and continued productivity growth as EM economies “borrow” technological advances from developed economies, all support our projected real return for EM currencies of 3.9% a year over the next decade.
Given recent price and economic momentum, we are reasonably confident the bear market in EM assets—five years long for EM equities and currencies, and three years long for EM local currency bonds—came to an end in January 2016, and the early stages of a bull market look to be well underway. We would all do well to recall David Ricardo’s counsel: 10 months into a bull market is no time to cut and run.
Time to Throw Your Hat In?
Most investors believe the best time to invest is when uncertainty is low and valuations are attractive. But these conditions rarely coincide with each other. Most investors opt for “less uncertainty” over “attractive valuations,” and end up chasing past performance along the way. We’ve often said bargains don’t exist in the absence of fear, and that fear is usually amply justified. For this reason, we believe the better approach is to invest in attractively valued assets while fear and uncertainty, although elevated, are beginning to fall. Such opportunities don’t present themselves very often. Today’s historically attractive valuations, deeply depressed currencies, and positive momentum—both price and economic—compose a very rare hat trick for emerging market equities, local bonds, and currencies, adding up to a region with strong potential for long-term outperformance. We’ve thrown our hat into the rink. Will you?