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

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.

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.