Future returns are all about the price you pay. With Latin America’s below average valuation and link to the global commodity boom, the region will outperform the world’s other regions. China is still overpriced and suffering from monetary hangovers.
Latin America and Europe look attractive
Comparing regional valuations on cyclical adjusted price earnings (price over average five year’s earnings per share) we see that Latin America and Europe deliver the most attractive valuation (see chart below) and with an earnings yield of 6.0 and 6.7 percent respectively the regional stock indices add a decent margin of safety. Contrary, China still looks very expensive compared to other stocks markets and particularly when you take into account the continuing monetary tightening.
Despite Europe having a higher earnings yield (lower valuation) we are slightly more positive on Latin America as its exposure to growth in global agricultural and energy markets will propel the region's companies higher in terms of earnings and valuation; and this is despite a large part of the population suffering from surging food prices. Also weighing on Europe’s potential is the sovereign debt crisis still present without any real solution in front of us in the short term.
The risk to our view is naturally the political development in Latin America and therefore you can diversify through an ETF such as the iShares MSCI EM Latin America, but also a derailing of global growth could hurt the region. However, the latter will hit stocks across all regional indices.
China still has hangover from massive quantitative easing
Despite Chinese stocks having significantly underperformed in global stock markets (see chart below) the high valuations of Chinese stocks still make them less attractive on a global basis. Also, China itself is still having massive hangovers from its historical quantitative easing that was initiated following the collapse of Lehman Brothers, as the country’s policy makers panicked. The flood of money into China has accelerated inflationary pressures (with massive pressure on wage rates) which policy makers are fighting by tightening monetary policy aggressively. This will have an impact on Chinese stocks as it will squeeze liquidity somewhat in the next 12 months which we know is negative for stocks.
We suggest two strategies to attack current valuations in stocks
The simplest strategy is to be only bullish on Latin America and Europe through the ETFs iShares MSCI EM Latin America (denominated in GBP) and iShares MSCI Europe (denominated in GBP) as these regional indices will perform better relative to other regional indices.
A more balanced approach is one that hedges some of the market risk out of the equation. In other words, that entails being bullish on Latin America and at the same time bearish on China with the latter through the ETF iShares FTSE A50 China Index (denominated in USD). The main risk to this play is if the spread increases - i.e. if China surges while Latin America falls. However, global stock indices are highly correlated so the probability of this happening is limited.
Price matters most for future return
Some might disagree with our approach. However, overall valuations in regional stock indices are driven by valuations on large companies and they usually derive their sales globally so country/regional GDP growth delivers very little added value to country/regional selection; it is the price you pay that matters most. One year forward earnings growth also adds little value to stock selection. In fact, we know that cyclical adjusted price earnings matter for future returns (see chart below).
Based on this backdrop we believe Latin America and to a certain extent European stocks will outperform in global stock markets. On the other hand, China will only deliver when speculative euphoria comes back into the stock market which could happen as the country’s savers are still receiving a negative real return on their cash deposits.