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When will we see the turning point in EMs?
EMERGING markets (EMs) have seen US$73 billion in outflows in 2015 versus US$23 billion in 2014. EMs continues to face challenges near term driven by
- higher leverage ratios;
- earnings downgrades driven by oil and foreign exchange and
- lower, and deteriorating quality, of return on equity.
Investor sentiment is very much negative towards the asset class. Our relative preference within EMs is Asia over Latin America and EEMEA (Eastern Europe, Middle East and Africa). We have been underweight EMs versus developed markets (DMs) for a number of years. We expect -5 per cent earnings per share growth for MSCI EM for 2016, versus consensus of positive mid single digits.
At some point this trade will reverse if EMs became fundamentally more attractive than DMs and/or EMs capitulated and looked cheap versus history. What may also cause a trading rally (this would be tactical) against our strategic view, which we would participate in, would be if the US Federal Reserve went on hold, the yuan stabilised, along with a China stimulus and a bounce in commodities - this would be a tactical trade.
For 2016, we therefore focus on better equity returns from DMs over EMs within our global equity portfolios. Improving domestic demand is a major driver for growth due to a better employment situation supported by easy monetary policies over the past few years.
In the United States, a recovery is on track as deleveraging and wage growth support domestic consumption. In Europe, the unemployment rate remains high, but it has declined from its peak at 12 per cent to below 11 per cent now.
In addition, we are witnessing wages picking up, which is a very positive sign. The European Central Bank recently hinted at the possibility of additional quantitative easing (QE) as early as March 2016, after QE extension (to March 2017) and a deposit rate cut in December. The Bank of Japan has also adopted a negative interest rate strategy to spur banks to lend in the face of a weakening economy.
All in all, we expect plenty of liquidity from DM central banks. We expect high-single-digit earnings-per-share (EPS) growth for all DM regions driven by the technology, healthcare, financials and consumer sectors.
Within EMs, prefers Asia to LatAm and EEMEA
Within EM equities, we continue to prefer Asia ex Japan over Latin America and EEMEA. MSCI EM Asia remains weighted towards tech, consumer discretionary and financials which are our preferred sectors.
There is scope to further ease monetary policy in most of Asia versus end of easing/start of tightening cycles in LatAm and parts of EEMEA. Most of the Asian markets, being commodity importers, stand to benefit from a commodity slowdown while commodity export-dominated LatAm and EEMEA suffer from a lower-for-longer commodity scenario.
Over the past two decades, China has been the main growth engine in Asia. While China is going through structural reforms to reduce overcapacity, credit overhang in the corporate sector, and shifting from an export-driven to a domestic-driven service economy, we expect economic growth to slow down. We don't see a need to adjust our cautious forecast as yet. At 6 per cent, we already have a relatively conservative growth forecast for Chinese gross domestic product growth in 2016.
We believe that China's domestic equity market is of limited use in gauging the country's longer-term fundamentals, but is rather a measure of Chinese (retail) speculation. The Chinese market should remain policy driven and therefore volatile. We remain moderately bearish on the China growth picture but expect more reforms and look to the next National Peoples' Congress (NPC) meeting in March to gain more clarity.
We like Taiwan, India and the Philippines within Asia - preferring the tech names in Taiwan and their ability to export into US growth, India's structural story over the medium and long term, and the Philippines domestic story, backed by an election year which should benefit some of the consumer names. Overall, Asia, like the rest of the world, will remain challenged and therefore we are looking to be more selective, flexible and tactical in our portfolio allocation.
EM currencies, overall, remain vulnerable to the stronger US dollar on the back of Fed tightening and attractive US real yields. The large portion of US dollar-denominated liabilities in the EM corporate, private and sovereign sectors is a big burden.
There is a misconception that EM equities are currently trading at a significant valuation discount to the S&P 500 Index. We believe that consensus earnings estimates are too high. Earnings expectations for EM equities still need to be revised down to more realistic levels (note above MSCI EM 2016 EPS forecasts versus consensus).
EMs will require economic and political structural reforms, a successful adaptation to the low-commodity-price environment and a subsequent earnings recovery to trigger a strategic reassessment.
- The writer is chief investment officer, Asia Pacific Deutsche Asset Management