Richard Titherington, Chief Investment Officer, Emerging Market and Asia Pacific Equities, JP Morgan Asset Management
Emerging market equity valuations are unusually attractive because the asset class is burdened by sluggish global growth, a rising US dollar and falling commodity prices. As a result of bearish sentiment, emerging markets have only been as cheap as they currently are 5% of the time since 1989, suggesting that investors with a long-term focus have an attractive entry point. Meanwhile, the outlook for Japan remains positive and that market is also inexpensive relative to the developed markets.
Fundamental challenges for emerging markets
The cumulative headwind effect of lower global economic growth, a strengthening dollar and lower commodity prices has prompted slow EM growth, a disappearance of earnings growth (in the aggregate), and complications arising from currency weakness. Meanwhile, concerns about China’s cycle have intensified fears of either an intra-Asian currency war or a further breakdown in Chinese growth that exacerbates the three headwinds that the emerging markets have already been navigating.
In order to for bearish sentiment in emerging markets to reverse, we’ll need to see changes in the real economy. There are three catalysts for investors to watch.
First, we’ll need to see currency stabilisation, arguably the most important factor. If the Chinese government is able to stabilise the Renminbi, that may help other EM currencies and commodity prices. Secondly, we’ll need to see some improvement in the economic picture and the final catalyst will be a corporate earnings recovery.
The long term investment opportunity
Despite the disappointing performance of emerging markets since 2011, they are still expected to recover to higher growth rates than developed markets over the longer term and the asset class overall has become too big to ignore.
For example, emerging markets are home to 85% of the world’s population and more than 50% of its global GDP growth. Although they are still only 12% of global equity market capitalisation, this is changing quickly, particularly with the increasing liberalisation of China’s equity market.
Current valuations present an attractive opportunity for long-term investors. Historical analysis from the past 20 years shows that investors can potentially enjoy reasonable upside when entering the markets at such low valuations. We can judge this based on the price-to-book ration of the EM index, as that metric tends to be a good proxy for investor sentiment.
For MSCI Asia Pacific ex Japan, the 12-month average return subsequent to entering the market at 1.3x price to book is 64%. For the MSCI Emerging Markets, the 12-month average return subsequent to entering the market at 1.3x price to book is 49%.
Importantly, emerging market currencies on average are also back to levels last seen during the crisis period in the late 1990s.
It’s important for investors to maintain a focus on the long-term opportunity that remains in emerging markets, throughout what are sure to be continued short-term fluctuations.
Reasons to be optimistic about Japan
The Japanese equity market has been impacted by the China currency devaluation this summer and subsequent volatility surrounding lower commodity prices, but the fundamental characteristics haven’t changed. Japanese companies continue to post healthy profits growth and political stability remains in place, with the government committed to ending deflation via Abenomics.
As investors we are geared towards longer term themes such as inbound tourism, factory automation and improving corporate governance. We believe these type of companies are generating sufficient free cash flow to weather the storm and are well-positioned for structural growth trends.
The Japanese stock market trades on a price-to-earnings (P/E) ratio of 14x. This is cheaper than the US, which trade on a P/E of 15x. The book value of the Japanese market continues to trade at a discount to global levels, while the earnings growth outlook remains very attractive, suggesting that Japan offers value to investors.