With US monetary policy keeping bond yields low and driving investors out of cash and into risk assets, the darlings of the equities world – emerging markets, particularly Asia – should be awash with liquidity, with valuations shooting through the roof.
But it hasn't happened, and probably won’t in the near term, says Julian Mayo, London-based co-head of portfolio advisory at emerging-markets boutique Charlemagne Capital. “If there’s one thing that has surprised me, it’s how the valuations gap between emerging and developed market stocks has yet to emerge,” Mayo says.
The past 25 years have seen several examples of emerging-market euphoria that pushed valuations skyward: 1987 (right before the Wall Street crash), 1993 and 1996-97, in the run-up to the Asian financial crisis.
The difference between those cases and today is that, before, investor exuberance over emerging markets occurred while they were also bullish on developed-market stocks. Today, there is little excitement over the sluggish, debt-laden Western markets.
“The relative gap of long-term potential outcomes between high-growth emerging markets and sluggish Western markets has never been greater,” Mayo says, noting that this outlook is already reflected in fixed-income markets, where spreads on emerging-market sovereigns are at all-time lows. “The bond markets know something good is happening in emerging markets, that the risks of default are much lower. But equity markets are not following.”
Mayo says that average emerging-market price/earnings ratios are around 15x expected 2010 earnings, versus 12-13x for developed markets.
“There should be a gap,” he says, noting that in times of euphoria, EM valuations have risen to 25x or more. Mayo says such a gap will emerge, but not for several years.
“Maybe we're too close to 2008,” he wonders. “For now, there are a lot of sceptics, or investors who are still just waking up to the reality of the world. A lot of our clients haven’t quite bought the idea. If everyone believed in emerging markets, it would be reflected in the price.”
Alternatively, he reasons that many investors – public pension funds, insurance companies and so on – do like the idea of emerging markets, but don’t know how to get exposure, particularly when the major index benchmarks underweight Asia relative to its economic size. Many investment consultants in the West lack in-house expertise in emerging markets or research into EM fund managers.
It will be several years before emerging markets face a valuations problem, or managers face capacity constraints, Mayo says.
He notes that correlations among emerging markets have risen, making this environment one more suited to stock-pickers; valuations at the company level can vary widely.
Mayo remains wary of companies that are too expensive, and would rather capitalise on domestic demand in big emerging markets via the relatively unloved financial sector than pricey retailers or consumer manufacturers.