Following the recent Emerging Markets weakness, driven by dollar strength, tighter financial conditions in the US and, in some cases, domestic politics, market watchers are looking at EM assets again.
The chart below shows that FTSE EM equities have moved to a c.21% PE ratio discount to FTSE World equities (dark blue line). In PE terms, FTSE World equities are trading at 15.5x earnings; EM equities at 12.2x.
However, we need to be aware that Emerging Markets offer different exposure to industry sectors in comparison with Developed Markets.
As the chart below shows, FTSE EM is heavily overweight financials, oil and gas and materials, compared with FTSE World.
None of these sectors are much loved and continue to face structural headwinds
Financial stocks have, of course, underperformed since the financial crisis, even in developed markets (Investors EM specific concerns include high levels of debt and leverage). Oil and gas have recovered of late, but only after several years of weak performance. And materials stocks face the prospect of weaker demand from China.
Although emerging markets have seen a rapid growth in their technology weighting in recent years, this is somewhat distorted by China’s large tech stocks, and not a reflection of EM as whole.
What happens if you reweight the EM Index to reflect developed market sector exposure?
When we reweighted FTSE Emerging to FTSE World Sector Weights, we found the 12-month forward PE more or less at parity (the light blue line in top chart). This is in contrast to 2016 when EM moved to a double discount.
This reminds us that it is important to understand what is being captured by a relative value shift in terms of the interaction between the valuation ascribed to sectors and the difference in sector exposure.
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