While not enjoying 2017-like returns, stocks are having a decent year. Developed market equities are up more than 4% in dollar terms. Things look even better in the United States, with the S&P 500 Index up around 7%. As many markets started the year at already full valuations, investors could be forgiven for thinking that there are few bargains left. Interestingly, much of Asia appears really cheap.
As of the end of July, Japanese equities remain the cheapest equity market in the developed world. The Topix Index (TPX) is trading at 1.8 times price-to-book (P/B), roughly half the level of the S&P 500. The current discount is close to the lowest since 2012, a period that preceded a three-year, 150% rally.
The Asian discount applies to a number of emerging markets as well. For example, Korean equities remains not only the cheapest equity market but by some measures the cheapest asset class (see Chart 1). Korean equities even look inexpensive relative to the already discounted emerging market space. The current valuation represents a 40% discount to the rest of EM, the largest discount since the 1997 Asian financial crisis.
Why so cheap?
Historically, many of these markets have traded at a discount. Korea normally screens cheap. Similarly, for many years Japan has traded at a discount to the rest of the world. However, while the discount may have been justified in the past, much has changed in recent years.
Japan has witnessed a significant improvement in both corporate governance and profitability. The return-on-equity (ROE) for the TPX now stands at 11.1%, close to a multi-decade high and more than twice the level of six years ago. Japan’s low valuation seems even harder to justify given this improvement in corporate profitability and still ultra-accommodative monetary conditions.
Rather than fundamentals, today’s Asia discount can likely be attributed to three trends: stellar U.S. earnings growth, a stronger dollar as a headwind for EM stocks and rising trade frictions. In the United States, 20% earnings growth has led many investors to abandon international markets. At the same time, a stronger dollar has created a genuine headwind for emerging market equities. Finally, many countries in Asia have been vulnerable to rising trade concerns. The Shanghai Composite is down roughly 15% from the May peak and more than 20% since late January.
While trade and the dollar remains real issues, these concerns already appear reflected in the price. As I discussed recently, the broader emerging market complex is cheap, with countries like Korea and Taiwan looking cheaper than most. As a result, Japan and much of Asia appears to be that increasingly rare find: a bargain.