(Bloomberg) — Emerging market stocks are trading at the steepest discount to U.S. equities since the Covid-19 panic in March 2020 as nervous investors look for growth opportunities elsewhere.
For every dollar of future earnings, investors are now paying 45 percent less to own EM stocks than US stocks. Before Covid, the stock index had not seen such a large discount since 2006.
Today’s large gap is primarily due to two things: Analysts have raised the average earnings forecast for the MSCI Emerging Markets Index by 5.2% over the past two months, a larger increase than the S&P 500 Index, which rose 1.9%. At the same time, EM stocks are lagging behind the US as investor sentiment remains cautious.
“The current low valuations of emerging markets compared to the S&P 500, despite improved earnings forecasts, reflect investor caution,” said Nenad Dinic, equity strategist at Bank Julius Baer in Zurich. “This caution is linked to the ongoing debates about US economic growth and the potential impact of a Republican victory in the upcoming elections, which could lead to high tariffs and weigh heavily on sentiment in emerging markets.”
The EM equity index trades at a price-to-earnings ratio of 11.9 times, based on 12-month estimates compiled by Bloomberg. In contrast, the S&P 500 trades at 21.5 times.
Just over three years ago, investors were only accepting a 28 percent discount to emerging market equity price-to-earnings ratio. That gap has now widened to 45 percent as the impact of a stronger dollar, stubborn inflation and elevated interest rates weigh on growth and corporate performance in emerging markets.
“Emerging markets are very cheap, unloved and undervalued,” says Ygal Sebban, investment director at GAM UK Ltd. “The US is still taking all the credit.”
The MSCI EM index is expected to underperform the US index for the seventh year in a row – even though it has gained almost 8 percent since January 1 alone.
For emerging markets to outperform, global growth is crucial, Sebban said.
“We need a soft landing in the US, enough to get the Fed to cut interest rates that will help emerging market interest rates and currencies. We also need some clarity on US tariffs and no drama on the Chinese growth front,” he said.
Asset managers also point out that a sustained weaker dollar and more emerging market companies comparable to the so-called “Magnificent Seven” in the USA are needed to attract investors.
“In the long term, the main problem in emerging markets is that there are very few innovative companies there,” says Mark Matthews, head of Asia research at Bank Julius Baer in Singapore. “Since about 2010, investors have been focusing on innovation, and so emerging markets as a whole have fallen behind.”
Analysts, for their part, are upgrading their earnings forecasts for emerging markets as expectations grow that the US Federal Reserve will ease monetary policy and support interest rate cuts in developing countries. Technology companies are at the forefront of this surge, with consensus estimates for this group’s earnings nearing record highs.
Similar to the U.S., excitement around artificial intelligence has been the reason for this year’s rally in emerging market stocks. However, there are also concerns that the sector’s expected financial performance may not materialize anytime soon. Investors are waiting for the results of the most closely watched AI stock, Nvidia Corp., due in late August, to gauge whether the sector’s gains can be sustained.
Another reason for the rise in emerging market earnings forecasts is the weaker greenback, which is pushing up local currency forecasts converted to U.S. dollars. The MSCI EM Currency Index is on track for a second month of gains after hitting a record on Tuesday.
“The recent improvements in emerging market earnings forecasts are mainly due to stronger emerging market currencies and a weaker US dollar amid expectations of a gradual rate cut by the Fed,” Dinic said.
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