Emerging market equities, now trading at a discount to slower growing western markets, are beginning to look attractive by some measures (blue line below). Ceteris paribus, disciplined value investors may be inclined to increase positions as this discount widens further. But all else is not equal. Given the structural shift underway in emerging economies and the increasing likelihood of credit crisis in China, we believe the recent de-rating of emerging markets is more likely to represent a longer term inflection point. The EM discount is not yet extreme by historical standards.
The valuation of US equities, on the other hand, is quite extreme based on the same metric (green line above). We are still finding select opportunities at home, but if you believe profit margins are susceptible to the laws of gravity (we do) than current stock prices are even more expensive.
Fortunately, there is a silver lining for value investors. Or in the case of these charts – an orange lining. Developed Markets Ex-US are still trading at relatively depressed multiples of relatively depressed earnings. Note the spread between the orange and green lines in the chart above. Valuations look fair and are supported by fundamental and technical tailwinds. There is a strong structural case for owning high quality, multinational brands against this backdrop. Specifically, we expect a massive “trading up” in consumption in the developing world, compounded by an even greater “trading up” of capital flows into developed markets.
To be clear, Europe is far from fixed. But disciplined capital allocators are beginning to put money to work. European equities remain cheap. And while US profits are back above the prior cycle peak, the rest of the developed world has far more upside (orange line in chart below).
We have spent much of the past two weeks analyzing a potential investment well positioned to capitalize on the accelerating efforts of EU banks and governments to shed distressed assets in order to strengthen their balance sheets. More to come on this in coming weeks. In the meantime, maybe EM investors will Get Lucky. Personally, I never realized how much I missed Soul Train until I saw this!