You are here
Tech sector dazzles
ONE of the emerging markets’ (EM) success stories this year has been the outperformance of the EM IT equity sector, which has returned close to 38 per cent in the year to end-August following a total return of 18 per cent in 2016.
However, the sector’s outperformance stretches much further back. Since January 2013, the IT Sub- Index has returned 84 per cent compared to 4 per cent total return for the Morgan Stanley Capital International (MSCI) EM Index. This is even more remarkable considering that almost all the companies in the sector are based in Asia, meaning that the sector defied the significant GDP growth slowdown in China from 2011 to 2015 (see Figure 1).
The IT Sub-Index’s performance has been so consistently strong that it is now the largest weight (about 25 per cent) in the MSCI EM Index, overcoming two historical heavyweights: financials and materials (see Figure 2).
Despite the sector’s weight increase, the MSCI EM Index has only 75 companies, which is fewer than the number in five other EM sectors: financials, industrials, materials, consumer discretionary and consumer staples. Furthermore, the IT sector has a large company bias, with the biggest 10 accounting for around 20 per cent of the MSCI EM Index. These include three types of businesses: intermediate input producers (semi-conductors, eg, Taiwan Semiconductor Company), electronics goods producers (eg, Samsung) and IT services (eg, Alibaba and Tencent).
EM IT drivers
We have identified four principal factors currently supporting companies in the EM IT sector:
- The ongoing synchronised global recovery is boosting demand for IT services, electronics and intermediate goods;
- Low EM labour costs and the capacity to adopt new technologies/innovate continue to favour intermediate and final goods being manufactured in EM;
- Demand for IT services, intermediate goods and electronics benefits from the sheer size of Asia’s population. For instance, compare China and India’s combined population of about 2.5 billion with around 320 million in the US;
- Rising EM income per capita supports Internet penetration and therefore the use of electronics and Internet-related industries.
In our view, the importance of these drivers will evolve over time. The synchronised global recovery may hit a cyclical peak. Population growth will likely slow in China and labour costs should continue to rise in the region. However, none of these is likely to happen anytime soon. Indeed, some factors such as rising income per capita should continue to provide a significant structural underpinning for Internet penetration and hence the earnings prospects of IT services firms (see Figure 3).
All priced in?
The rally in the IT sector over the past few months hasn’t just been driven by animal spirits relating to the drivers described above, it also reflects an acceleration in earnings growth that started in early 2016. This has in turn fuelled consensus earnings prospects. Indeed, consensus earnings momentum (measured as the three-month change in Bloomberg earnings expectations) is currently materially stronger than in other EM sectors and the US.
Prices have broadly caught up with this earnings momentum already, so the upbeat earnings outlook appears to be largely priced in. As a result, valuations have also risen for the sector. Twelve-month forward price-earnings ratios, for instance, are close to the top of their post-crisis range, at around 15 times, and although they are higher than EM as a whole (about 12 times), they are still cheaper than for the US IT sector (about 18 times).
Wait for pullbacks
To sum up, we see the development of the EM IT sector as being structurally based and having long-term potential. EM Asia equities, and therefore EM IT, are already the biggest allocation in our Parvest Emerging Market multi-asset income fund. Valuations are not particularly expensive versus the US, but they are not cheap either, whether historically or relative to other EM sectors. However, the rally appears to us to be over-extended, so we would rather wait for a pullback before adding to our current allocation.
We have already flagged risks on the horizon, such as China’s fading credit stimulus and tighter monetary/financial conditions in the developed world. If these shocks materialise and reflect cyclical/ temporary adjustments, we would continue to favour increasing exposure to the structural EM IT story. W
Guillermo Felices is Senior Investment Strategist, BNP Paribas Asset Management; and Lydia Rangapanaiken is Research Analyst, BNP Paribas Asset Management