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Seeking the bright spot
EMERGING Markets (EM) are supported by a cyclical recovery in some important economies and expectations for earnings growth have improved. Furthermore, EM are generally under-owned and valuations are reasonably attractive.
However, uncertain global politics will potentially increase market volatility.
Emerging markets fundamentals
Consensus expectations are for EM GDP (gross domestic product) to improve from 4.2 per cent in 2016 to 4.6 per cent in 2017. This improvement is led by a cyclical recovery in Brazil and Russia, given low base effects and expected monetary policy easing.
EM should benefit from well supported Chinese growth as policy is likely to ensure abundant liquidity provision ahead of the 19th National Congress of the Communist Party this autumn.
Longer-term risks in China, including the economy’s increasing reliance on credit and lack of structural reform, look to be manageable for now. The renminbi has weakened by around 4.5 per cent as at end-January, and together with capital controls, this has alleviated depreciation pressure somewhat.
However, US dollar strength risks putting the spotlight back on Chinese foreign exchange policy.
EM have also generally improved their external balances since the 2013 “taper tantrum” which reduces their vulnerability to a tighter global liquidity backdrop. EM lost value in 2013 in response to the Federal Reserve’s announcement that they would gradually bring an end to their quantitative easing programme.
Valuations require earnings support
Over the past several years, consistently negative earnings revisions led to EM underperformance. We believe analyst expectations have become more realistic. Earnings expectations stabilised in 2016, supporting the EM rally, and they now point to earnings growth in 2017.
The MSCI Emerging Markets index is trading around 12x 12 months forward price-to-earnings (at end-January) which is in line with average. On a price-to-book basis, valuations are attractive, trading at around 1.57x. This is below the long-run average and reflects the current low level of return-on-equity in EM.
EM corporates’ capital allocation and cost efficiency have been improving. This should support profit margins and lift return-on-equity. Should the returns cycle improve and earnings start to meet and beat expectations, this would be a strong catalyst for stock market performance. The recovery in commodity prices and stabilisation in Chinese growth should be supportive, although recent dollar strength is likely to be a near-term headwind to dollar reported earnings.
Subdued global growth
EM benefit from global trading activity. Global economic conditions remain subdued although consensus expectations are for growth to modestly improve from 2.5 per cent in 2016 to 2.8 per cent in 2017.
There is speculation that a change in US policy can trigger global reflation and increase global growth. This is possible, but structural headwinds in areas such as demographics, productivity, infrastructure and regulation remain. There is a risk that any growth improvement is cyclical and short-lived.
Intra EM trade has grown in importance and these economies are less reliant on developed world growth than in the past. However, a continuation of subpar global growth would temper the positive of an improving EM domestic picture. Weak top line growth implies more self-help is required for EM corporates to drive earnings.
Tail risks revolving around world politics have increased and there is a busy political calendar in Europe in 2017. Potential policy change will have implications for all asset markets.
Post Trump victory, markets have moved quickly to price in a US reflation trade and stronger US economic growth. This has spurred concerns that the pace of monetary policy normalisation in the US will accelerate, leading to tighter liquidity conditions and a stronger US dollar. The US yield curve has steepened and EM have come under selling pressure. Historically, EM have underperformed developed markets in a strong dollar environment.
However, the US is late in the cycle with close to full employment. A fiscal package may lift the rate of growth, but accelerate inflationary pressure resulting in tighter monetary policy and a stronger US dollar. This in turn could choke off the growth recovery. Furthermore, current dollar strength may weigh on the US economy until the positive effects of any stimulus package are felt. Hence, there is scope for current expectations to moderate.
Meanwhile, potential changes to US trade policy carry asymmetric risk. Mr Trump’s protectionist standpoint is a potential negative for global trade and therefore EM. There is potential for negative headlines although policy action may be limited and selective given the mutual benefits of free trade, complex global supply chains and geopolitical considerations.
The impact of any change in trade policy will vary by country and stock and we will assess the ramifications as we see policy evolve. EM are generally under-owned and reasonably valued so any market overreaction may provide an investment opportunity.
Tom Wilson is Head of Emerging Market Equities, Schroders