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Are Emerging Markets Cheap?

Slowing growth is priced in, but a spike in global volatility continues to be a risk.

Patricia Oey, 12/07/2011

Emerging markets have been one of the worst-performing asset classes in 2011, weighed by heavy losses in markets such as Brazil and India. Some of the issues that affected emerging markets earlier this year include rising inflation and an anticipated slowdown in growth due to local tightening monetary policies and weaker export demand. And when global market volatility shot up in August and September, emerging markets dropped far lower than did U.S. equities, though not to the degree observed in late 2008. Investors in emerging markets were also negatively affected when strong risk aversion resulted in a rising U.S. dollar--in September, the Brazilian real fell about 16% and the South Korean won fell 9% against the U.S. dollar. Will emerging-markets equities have a better year in 2012?

Valuations in emerging markets (as measured by the MSCI Emerging Markets Index) are near 10-year lows, excluding 2008, which reflects slowing GDP growth rates and manufacturing activity. Emerging markets' trailing 12-month P/Es are also near five-year lows relative to that of the S&P 500. Most emerging-markets countries have more leeway to adjust their monetary and fiscal policies to support growth, and inflation risks have ebbed since earlier this year. Should global volatility recede to more normal levels, we think low valuations and proactive stimulus measures should support improving emerging-markets performance in 2012. But while we are comfortable with the fundamentals for most of the larger emerging markets, when sentiment regarding the Europe debt crisis become very negative, it will have an outsized negative effect on emerging-markets stocks, relative to developed-markets stocks.

The two largest emerging-markets ETFs both track the market-cap-weighted MSCI Emerging Markets Index-- Vanguard MSCI Emerging Markets VWO and iShares MSCI Emerging Markets EEM. These funds have heavy weightings in countries such as China, Brazil, South Korea, and Taiwan. We'll take a closer look at these markets to identify what some of the main drivers of these funds will be in 2012.

China
Pessimism reigns on Chinese stocks--the MSCI China Index fell 20.2% (in the year to date through Nov. 30), versus a decline of 17.2% for the MSCI Emerging Markets Index. The Chinese manufacturing sector contracted in November for the first time in nearly three years, which reflected declines in both export orders and new domestic orders. And while China has made progress in taming the real estate bubble, a construction slowdown may be difficult to afford as export growth slows. The weakening real estate market and uncertainties regarding the quality of Chinese banks' loan book are the two major reasons for the underperformance of the Chinese financial sector, which accounts for 34% of the MSCI China Index. The financial sector is generally the largest sector weighting in a Chinese cap-weighted index fund.

After a year of monetary tightening to address rising inflation, the Chinese government unexpectedly lowered the reserve requirement ratio for banks by 50 basis points on Nov. 30. This suggests that the government remains committed to maintaining high-single-digit GDP growth. It will be a difficult balancing act in the near term, as the Chinese government tries to stimulate growth without reflating an asset bubble, maintain control over the yuan exchange rate, and ensure stability in its banking and real estate sector. Given these risks, we are the least optimistic about the outlook for China in 2012 relative to the other major emerging markets. However, we expect the Chinese government to continue to take steps to stimulate growth into 2012, and this could provide a small boost to Chinese equities. Investors in broad cap-weighted funds such as VWO and EEM who are negative on China can consider reducing their heavy 17% China exposure by taking a short position in iShares FTSE China 25 Index FXI, whose holdings are very similar to the Chinese holdings of EEM and VWO.

Taiwan
Aside from China, we are more optimistic about the outlook for the other larger emerging markets. Taiwan accounts for about 11% in VWO and EEM, but it accounts for a significant 22% and 26% in popular dividend-weighted WisdomTree Emerging Markets Equity DEM and WisdomTree Emerging Markets Small Cap DGS, respectively. At this time, the Taiwan market, as measured by the MSCI Taiwan Index, is trading near a five-year trailing 12-months P/E low relative to that of the S&P 500 and the MSCI EM Index. This is due to Taiwanese companies' strong export orientation (exports account for 62% of Taiwan’s GDP), where slowing developed markets is expected to negatively affect corporate Taiwan. However, 50% of the MSCI Taiwan Index is composed of technology firms, which are positioned to capitalize on rising penetration of smart phone and tablet use, especially in the emerging markets. The index's second-largest sector allocation is financials (at 16%), which will benefit from planned regulation that will allow for stronger ties with Mainland banks. We also think that stimulatory measures in China may benefit Taiwan's material (15% of the index) and industrial (4%) sectors. However, one near-term risk is Taiwan's elections on Jan. 14. At this time, the incumbent Ma Ying-jeou, who has overseen strengthening economic ties between Taiwan and China during this four-year term, is polling with a very small lead over his main challenger who, if elected, will likely slow down the pace of economic liberalization with China. Should Ma lose this election, we think this would be a negative for Taiwanese equities.

Brazil
Like Taiwan, Brazil is another major emerging market that is trading at trailing 12-months P/E ratios that are near a five-year low relative to that of the S&P 500 and the MSCI EM Index. Inflation, which continues to be near the central bank's 6.5% limit, appears to be easing, and the government has started to move forward with fiscal and monetary stimulus. This should provide a near-term boost, as Brazil’s longer-term growth story--a relatively young and growing population and rising commodity exports to emerging markets--hits a speed bump due to slowing global economic growth. Two weeks ago, Brazil eliminated the 2% tax foreign investors have to pay when they purchase Brazilian equities--this law was instituted in October 2009 when strong foreign fund flows into Brazil drove a strong rally in Brazil equities and the Brazilian real. Miner Vale VALE, which accounts for about 15% of the MSCI Brazil Index, should benefit from planned domestic infrastructure spending ahead of the 2014 World Cup and 2016 Summer Olympics. Vale is also leveraged to China's economic growth and may benefit from a Chinese stimulus. Brazilian banks, the index's largest sector allocation at 25%, have healthy balance sheets and attractive long-term growth opportunities in consumer and commercial banking.

Patricia Oey is an ETF analyst at Morningstar.
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