Emerging Market Equities Are No Longer Undervalued

The author is Cambridge Associates, a provider of independent investment advice and research to institutional investors and private clients worldwide.

Cambridge Associates says that overweighting Emerging Markets, at Expense of U.S. Equities, may be best valuation-based bet. Also consider tilting allocations to cyclically oriented investment managers or an emerging markets index.

Emerging market equities, such as Chinese or Brazilian stocks, have drifted out of the undervalued category to the low end of the "fairly valued" range. Nonetheless, in the context of the pronounced macro uncertainty of 2013, they remain an appealing valuation opportunity for institutional investors, according to Cambridge Associates’ most recent Global Market Commentary.

"Today, emerging market equities offer the best risk-reward trade-off from a long-term perspective, particularly when compared with U.S. equities. Within emerging market equities, most of the discount is concentrated in cyclical sectors such as financials and energy, while ‘defensive’ and consumer-oriented sectors like consumer discretionary, consumer staples, telecoms and utilities all look relatively expensive," said Celia Dallas, Director of Investment Strategy Research at Cambridge Associates, a global provider of independent advisory services and research to institutional investors and private clients.

Although emerging market equities remain well above their 2003 deep discounts against developed markets, a discount does still remain. Emerging market equities now stand near their 2008 level of relative valuation, which proved to be an attractive buying point, according to Cambridge Associates. Nonetheless, they’re only "cheap" when compared with U.S. equities.

When considering such a portfolio tilt, institutions should, according to Ms. Dallas, consider the following factors:

Major headwinds — namely the U.S. debt negotiations, the crisis in Europe, and the possibility that China is in or will have a hard landing weighed heavily on emerging markets equities for much of 2012, and for good reason. True, if a global slowdown persists over 2013, emerging markets "may feel like a falling knife," according to the report, but any positive surprise, especially in China, could sharply raise values, particularly in the emerging markets’ cyclical sectors.

While risks remain on a cyclical basis, valuations should support relative outperformance once macro uncertainty lifts and the global cycle accelerates. Should concerns about macro risk re-emerge and emerging markets equities underperform U.S. equities in the near-term, this would provide an opportunity to expand such positions at more favorable valuations.

Institutions may achieve outperformance by locking in profits from emerging market consumer-related and defensive stocks and tilting allocations to more cyclically oriented emerging market managers or an emerging markets index.

China Expert Network
China Expert network