Chart Of The Week: Equity Risk Premium - EM Is Cheap Again

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Includes: ADRE, DBEM, EDBI, EDC, EDZ, EEM, EEMA, EEME, EET, EEV, EMEM, EMF, EMLB, EMSA, ESGE, EUM, EWEM, FEM, FLQE, GMF, HEEM, IEMG, KEMP, KLEM, MFEM, MSF, PPEM, RFEM, ROAM, SCHE, SPEM, VWO, XSOE
by: Topdown Charts

Summary

The equity risk premium provides a guide to how attractive it is to hold equities vs less risky government bonds.

The equity risk premium has improved materially for emerging markets.

All else equal, the improved valuation picture changes the dynamics in the risk vs return trade-off for Emerging market equities.

It's been a tough year for emerging markets as a perfect storm of political risk, a stronger US dollar, and slowing China growth have combined to knock them off a pedestal of previous solid performance. But for contrarians this is where it gets interesting, and where it gets really interesting is with the changing valuations picture.

This week's chart comes from a recent report, in which we undertook a comprehensive review of Emerging Market equity valuations.

The chart shows the equity risk premium for emerging market equities, and compares it against the USA and developed market equities.

EM equity risk premium chart

The equity risk premium provides an important lens on stock market valuation because it takes the earnings yield (i.e. the inverse of the PE ratio), and adjusts for the real yield (inflation adjusted long term government bond yield). Basically it's the compensation for taking on equity risk vs "safe" returns from government bonds. The higher the equity risk premium, all else equal, the more attractive it is to hold equities.

The chart actually holds a few key insights worth highlighting. First, the EM equity risk premium is trading slightly higher than where it moved to during the 2015/16 market corrections. So it is currently elevated, by EM standards. Second, in the post-2008 period, it is trading higher than usual against developed markets, which makes it attractive on a relative basis. So it makes EM equities look attractive vs their own history, vs government bonds, and vs their developed market counterparts.

At this point you might be tempted to say "yeah but is it cheap for a reason?" And there is some merit in this objection, and certainly the headwinds that have beset EM equities are not by any means all done and over with. Political risk still lingers, China's economy continues to slow, and there remains upside risk for the US dollar. But as the valuation indicators start to improve, my view is that this factor (valuation) starts to speak louder than other factors such as economics, monetary conditions, and the news/noise.

So with EM equities starting to look attractive on a valuation basis, it's worth paying closer attention as the risk vs reward dynamics undertake an important shift - and the kind of shift that we've seen before.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.