EM equities for the long run?

After performing poorly for much of the past year, emerging market (EM) equities have been showing signs of life. While this can partly be attributed to easing fears over China, it may also reflect a perception that they are now attractively valued. Admittedly, the valuations of EM equities are not especially low by past standards. But they are low relative to those of equities in the developed world. This is one reason to think that they could deliver higher returns in the long run.

Lower-than-average valuations ought to lead to higher-than-average returns in the long run, assuming valuations revert eventually to their average levels.

Of course, it may be unreasonable to assume that valuations will revert to their long-run averages, since structural changes may have caused the equilibrium levels of valuations to have altered over time. Notwithstanding this caveat, of the US stock market has been low at the outset of the year, the annual average real return over the next ten years has tended to be high (and vice versa).

The historical data for EM equities are far more limited than for US equities. Nonetheless, when the price/12m forward earnings ratio of the MSCI EM Index has been low at the start of the year, its average annual return over the next five years has tended to be higher, too.

"Granted, the current price/12m forward earnings ratio of the MSCI EM index is close to its own average of the past decade. But it is much less than the price/12m forward earnings ratio of the MSCI World Index of developed market equities, which is well above its own average over the same period. This is one reason why we think the prospects for EM equities are brighter than for DM equities in the coming years", says Capital Economics in a research note.