No. We continue to advise small overweights to Asia ex Japan or emerging Asia relative to US equities, but would not suggest investors add more substantial overweights unless they have an exceptionally long time horizon and the ability to tolerate substantial volatility.
The risks to emerging markets are well known. Commodity weakness, a slowdown in Chinese economic growth, falling currencies, and prospects for higher rates amid Federal Reserve tightening are key worries today. Corporate earnings are under pressure as global growth slows and exports sag, corporate non-financial debt levels have risen, and credit spreads have widened. The asset class is vulnerable to a vicious cycle of poor returns and risk aversion leading to capital outflows that further depress asset values, push currencies lower, and pressure interest rates higher, which in turn puts more stress on asset values, triggering more outflows. This cycle is particularly damaging to countries that rely on external funding to support current account deficits.
The very fact that these weaknesses are widely known is what makes the area of interest to long-term, value-oriented investors. Emerging markets equities have rarely been so cheap. The index as a whole trades at a cyclically adjusted P/E ratio of 10.7 and Asia ex Japan at 10.9, the third and sixth percentile of the post-1995 historical distribution, respectively. Emerging markets and Asia ex Japan have demonstrated strong subsequent performance from starting-point valuations equal to today’s levels or better. As you might expect, very undervalued periods are concentrated in the Asian financial crisis and the subsequent recession amid the tech/telecom bubble aftermath.
Cheapness in emerging markets today is based on the relative stability of earnings coupled with more limited price declines. Emerging markets equity prices have dropped 34% in US$ terms since their peak in April 2011, but actually did not peak in local currency terms until April of this year. Through the end of September, the market has fallen 18%, a drop in the bucket compared to the 52% peak-to-trough decline in 2007–08 and the 47% decline in 1997–98 when both earnings and prices experienced sharp corrections. Earnings expectations have been declining, although Asia ex Japan earnings (and to a lesser degree, emerging Asian earnings) have held up considerably better than the broad index thus far. However, the increase in debt as a share of GDP, concentrated in Asia, may pressure corporations should liquidity conditions continue to tighten. We are somewhat comforted by the fact that some of this risk has been priced in, and only 10.5% of non-financial debt is external debt.
Currencies have also cheapened to slightly undervalued levels, further mitigating risks today. However, even as currencies have fallen considerably, more adjustments are needed, and prospects for further declines and elevated volatility remain. Asian equities provide some shelter from currency risk, as roughly 40% of the MSCI Asia ex Japan Index and 36% of the MSCI EM Asia Index is denominated in Hong Kong dollars, which are pegged to the US dollar. Of course, Asian equities do remain exposed to currency weakness, particularly if China seeks to further devalue the renminbi, or the Japanese yen continues to weaken, setting off devaluation by regional trade competitors. Although the renminbi needs to depreciate further given stress in the Chinese economy, we believe a major devaluation is unlikely.
A repeat of the late-1990s emerging markets crisis seems unlikely today. The prevalence of flexible exchange rates, development of local currency debt markets, and higher foreign currency reserves have changed the character of emerging markets, making systemic crises less likely. Flexible exchange rates allow for gradual currency adjustments (in contrast to more disruptive breaks in pegs), local currency bond markets allow for better currency matching of income to liabilities, and higher foreign currency reserves allow for more controlled currency depreciation amid capital outflows. Indeed, many countries today maintain adequate foreign exchange reserves to cover short-term external debt and foreign bank claims.
Overall, we judge that the valuation discount provides an attractive opportunity for small overweights to Asia ex Japan or emerging Asia relative to US equities. Emerging markets equities, both in aggregate and specifically in Asia, are now very undervalued, currencies are undervalued, and investor outflows have retraced much of the cumulative net inflows seen over the period from 2009 to early 2013. A focus on Asia ex Japan or emerging Asia relative to US equities may prove more defensive than broad emerging markets given Asia’s stronger financial position (e.g., larger current account surpluses and higher foreign exchange reserves) and ability to benefit from lower commodity prices as net commodity importers in aggregate. However, investors initiating or maintaining such overweights should size them carefully in recognition that these assets may not outperform until estimates for both global growth and/or regional earnings are upgraded, and the timeframe for this has become more uncertain.
Celia Dallas is Cambridge Associates’ Chief Investment Strategist.
Related recent publications:
VantagePoint: Fourth Quarter 2015
Emerging Markets: Putting a Premium on Patience
Assessing the Likelihood of Another EM Currency Crisis