Photographer: Waldo Swiegers/Bloomberg

The Fight for Yield Has Crept Into Emerging Market Equities

Low government bond yields in developed markets mean more demand for emerging market equities, according to UBS AG analysts.

A global fight for yield has boosted the appeal of dividend-juicy stocks around the world.

What's surprising is where developed-market investors are now staging this battle — in emerging market stocks — and the justification that's involved: low bond yields in their usual domain.  

"Investors are switching into EM stocks for yield 'income' given a lack of bond income in developed markets," UBS AG analysts led by Geoff Dennis write in a report published on Tuesday.

That turns on its head the traditional way that investors have viewed EM equities. The stocks are typically seen as a bet on rising global growth prospects and as such, are bought for capital gain rather than income. What's more, the volatility of EM equities, particularly taking into account currency effects for dollar investors, can overwhelm positive carry, which challenges stock valuations based on interest rates.  

Fixed-income portfolio managers who have a mandate to also buy equities, and are known as cross-over investors, are casting emerging markets in a new light, say UBS analysts. 

"EM equities are usually bought for growth (although not in the last five years) or for beta to seek outperformance in rising global markets. EM is usually only viewed as a 'yield play' if investors want to adopt a defensive posture in the face of weak global markets. However, at present, we are hearing more and more about investors looking for 'yield' in EM as a way to play rising markets, in a world where growth remains, at best patchy. This hunt for yield in EM appears to be a particular focus for global investors who have been underweight in EM for several years and are now looking for 'cross-over' opportunities."

In recent months, foreign flows into EM stocks have jumped even as the outlook for dividends, economic growth, and corporate earnings haven't materially changed.

Emerging-market stocks don't look cheap on an absolute basis, either when looking at forward earnings, or dividend yields, the analysts say. However, the EM dividend yield relative to the yield on the benchmark 10-year U.S. Treasury is close to its highest in recent years, and well above the long-term average gap of minus 108 basis points.

The irony is that little has changed valuation-wise for the yield on EM dividends, which have remained in the same 2-3 percent range for much of the past 15 years. And there's no bullish case for EM dividend yields relative to developed-market yields either, the strategists say. What's more, EM dividend yield income has been above DM bond yields since late-2012. 

What's changed, however, is the rich valuations of investment-grade government bonds.

The UBS team's focus on the EM dividend potential relative to Treasuries, therefore, highlights the extent to which low bond yields have upturned the traditional role of EM stocks. 

The valuation argument put forward by UBS echoes a well-known theory for comparing stock valuations with interest rates, known as the traditional Fed model. The latter suggests stocks will remain attractive relative to bonds until the S&P earnings yield reaches the yield on the 10-year note. So even when stocks seem expensive from the perspective of their price-to-earnings ratio, either on a forward or trailing basis, some investors reckon depressed yields in developed markets justify snapping up equities, citing the Fed model theory, which was popularized by former Federal Reserve chief Alan Greenspan in 1997. 

Even so, there's no evidence stock performance in the long-run has anything to do with underlying interest rates. 

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