While emerging markets are more reasonably priced than in late 2010, we still believe investors should maintain an overweight to developed markets. One potential exception for more tactically oriented investors is Russia.
At the end of 2010 we recommended an overweight to developed market equities. While we subscribe to the long-term thesis favoring emerging markets, our logic was and is that a combination of cheap relative valuations in developed markets and growing inflationary pressures in emerging ones favor large companies in the developed world. Year-to-date that theme has played out, with developed markets significantly outperforming emerging markets. We would maintain this position going into the second quarter.
The problem with emerging markets in late 2010, and to some extent today, is not a lack of good news but simply the fact that much of the good news is already reflected in prices. Back in December emerging markets were trading at a scant 6% discount to developed ones, the tightest valuation spread of the past decade. Over the last ten years, emerging markets have typically traded at around a 25% discount to developed ones.
Given the fact emerging markets will grow faster than developed markets over the long-term, we would expect this valuation spread to contract over time. However, with inflation accelerating it seems premature for emerging markets to trade close to par versus developed countries. Over the past three months, the spread between emerging market and developed market valuations has contracted a bit. Emerging markets now trade at a 13% discount to developed ones; but this still appears too tight given the current headwinds facing emerging markets, notably inflation (see chart below).
Relative P/E Ratio Emerging Markets vs. Developed Markets (2001-Present)
Source Bloomberg 2/28/11
While inflation has stabilized in most emerging markets, it is still by-and-large well above central banks and our own comfort zone. In fairness to the central banks of these countries, their battle against inflation is being complicated by the recent surge in food prices, which is particularly problematic for less developed countries. In China 1/3 of the CPI basket is driven by food prices; in India the percentage is closer to ½. As a result, when food prices rise this has a disproportionately large impact on inflation in most emerging markets.
While we believe that emerging markets will bring down inflationary pressure in the back half of 2011, persistent inflation and relative valuations suggest that for now, developed markets still appear the better choice.
That said one particular market does appear unusually cheap: Russia. A lack of corporate governance and transparency prevents us from recommending this market over the long-term; however from a tactical perspective the market looks interesting. Russia currently trades for 6x earnings. And unlike China or India, which are negatively impacted by higher oil prices, Russia is a natural beneficiary of the spike in crude. Based on our preliminary model of emerging market valuations, Russia appears to be the one emerging market that is significantly undervalued.
For potential iShares solutions see this week’s Monday Market Calls.
Source: Bloomberg
