Surging valuations of emerging market stocks mean that investors in many markets are no longer receiving a justifiable risk premium, according to investment house Legal & General. UK and US companies are more attractive opportunities, the firm claims.Britain, America and to a lesser extent Japan still present genuine opportunities for investment, you're still being paid to take the risks for owning those markets, said Julien Garran, head of asset allocation at L&G Investment Management.
Comparing the price/earnings ratio of the UK market with a range of less developed countries illustrates his point. Investors in the Czech Republic pay 50% more to get the same earnings stream. The story is similar in Russia while Hungary, Poland and Turkey are also more expensive than the FTSE.
Using a Dividend Discount Model to attempt to account for future income streams, Garran argues that the implied equity risk premia in the U.K., Italy and the US are well above those of South Korea, Russia and Hungary.
ÒWeÕre not being paid enoughÓ to take up the risks associated with the latter markets, Garran asserts. His worry is that a slackening in the flow of funds into some countries would force interest rate increases and thus stifle domestic consumption. The case of Iceland, which suffered slumps in its currency and equity markets in the past two months, is a poignant warning, he notes.
Emerging market countries particularly vulnerable include those running current account deficits such as Hungary, Turkey and South Africa, according to Garran, who claims a growing distinction will be made between these and more fundamentally sound developing countries.
The overinflation of emerging equity markets has been fuelled by cheap credit, encouraging carry trades which have capitalized on huge discrepancies in yields, GarranÕs colleague, economist Andrew Clare suggests. Investors are systematically underestimating the likelihood of big market swings, he argues, noting that implied volatility of the S&P 500, derived from equity market options, is at its lowest in more than 15 years.
ÒWe believe that in some areas of the global financial markets, investors, seduced by the availability of cheap money, are probably underpricing risk. The prospect of a sobering correction in some of these markets seems high,Ó Clare notes in his monthly research report.
Now that interest rates in developed country are on the up, the time has come for L&G to reassess the merit of gambling on the higher returns of historically vulnerable economies but the runaway growth rates of many emerging countries look likely to continue luring investors despite their warning.