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Bill O'Neill, CIO, Merrill Lynch Wealth Management

Emerging market equity valuations begin to look attractive

The corollary to the recent falls in emerging market equities is that valuations begin to look attractive, says Bill O’Neill, EMEA Chief Investment Officer of Merrill Lynch Wealth Management…

The MSCI Emerging Market Index is trading (as at end September) on an 8.8x one year forward price earnings ratio, nearly 20% below its average since 2002. Similarly, on a price to book basis at 1.6x, the index is around 27.5% below its average since 2004. The argument is not clear cut, however. Relative to the MSCI World Index, the emerging market index relative P/E ratio is 10.8% above the average; on a price to book ratio, the relative ratio is 3.1% above average.
Given the extent of recent falls, what can history tell us, if anything, about the size and timing of the subsequent rebounds? From 1999 until the present, there have been 9 quarters (including the last) out of 51 in which the MSCI Emerging Market Total Return Index has fallen by 10% or more. The index performance one year later from each downward quarter has averaged 5.3% but there is an even split between positive and negative performances so a clear pattern is absent. A more useful turning point indicator for emerging markets to outperform has historically been the level of net purchases of global emerging market equities. When net outflows from developing nations peak, the turning point typically occurs as emerging markets on average outperform their developed market counterparts, one year forward.
Looking forward to year end and into 2012, emerging markets are expected to show some attractive features. With expected EPS growth of 16.5% for full year 2011 and 12.3% in 2012 (compared to 4.1% and 12.4% for the MSCI Europe ex-UK Index) and with dividends per share anticipated to grow at around 10% in both years, investors might reconsider emerging markets once again when some clarity regarding the eurozone crisis is eventually established. We believe, however, that it is too early to add to risk markets at present given political uncertainties within the eurozone and with the jury still out on whether a global slowdown will be fully evidenced. However, the attractive features of many emerging markets, such as high growth rates, low levels of government debt compared to Western economies and an ever growing domestic consumer base, should offer long term support. From a sector perspective, look for themes centred on yield, growth and quality, with a focus upon the burgeoning middle class consumer.

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