Emerging markets (EMs) have had a better start to the year following a dismal 2018 marred by the US-China trade dispute, a stronger US dollar, a hiking Federal Reserve (Fed) and slower growth exacerbated by deleveraging. However, it remains to be seen whether the factors behind the rebound are transitory or herald the start of an upward trend.
So far, the rally has been relatively superficial, driven more by expanding multiples than by earnings increases, on the back of the Fed’s rate-hiking pause and more positive trade talks. Global investors need to be cautious, therefore, as the hot money flows into EMs could just as easily switch direction if more robust EM GDP and earnings growth fails to materialize. While there are hints of stabilization, especially in China, investors should be prepared for a more fundamental EM recovery to take time.
Against this backdrop, we remain cautious and selective on EMs. The universe is highly heterogeneous and the prospects for earnings and GDP growth differ markedly between countries and sectors. Moreover, given structural changes in inflation expectations for EMs, certain countries could provide more developed market (DM)-like returns over the next five to ten years, so yield-sensitive investors may need to consider higher allocations to active EM strategies to capture the same levels of return in the future.
Fundamentals Begin to Stabilize, But At Lower Level
While EM equities have risen 8.5% year to date and continue to trade at a discount to DMs, they have underperformed the S&P 500 Index and are still down 4% on a 12-month basis. A more visible measure of improving global liquidity has been the compression of EM debt spreads over US Treasuries. But while monetary and geopolitical conditions have improved and some fundamentals such as return on equity and profit margins are showings signs of stabilizing, they are doing so at a lower level. Trade volumes have also yet to recover.
Earnings estimates continue on a downward trend as shown in Figure 1, with the majority of downgrades hitting the important tech sector. Until these flatten out or start to rise, it is hard to see how stocks could make further progress; much of the gains from likely trade reconciliation and a more lenient policy response appear to be priced in.
However, it is worth noting that while EM earnings revisions have continued to be mostly downward, the ratio of upward to downward revisions has been on an improving trend over the last few months, particularly in Asia ex-Japan. Further, much of the negative estimate revisions have been in the Information Technology (IT) sector—an area more afflicted by global cyclical factors than EM-specific factors. Meanwhile, countries with lower forward price-to-earnings mulitples have benefited most from the recent stock rally, including Russia, Turkey and China.
China Stimulus Provides Some Support
From a short-term cyclical standpoint, we would expect China’s latest fiscal and monetary stimulus to provide some support at home and across the region. Total social financing for January saw a sharp increase as this stimulus started to come through, although February’s figure was lower than expected. Overall financing for the first two months of 2019 has been RMB 1 trillion higher than the same period in 2018. Much of 2019’s financing has gone into short-term loans for companies, so the stimulus is unlikely to be prolonged (see Figure 2) given the already high levels of corporate leverage.
Recent comments by the Chinese premier also suggest this latest stimulus is very different from that in 2015/2016; it is designed to cushion the effects of slower growth on highly levered businesses and to preserve jobs rather than to boost overall economic growth. China recently lowered its expected growth rate for 2019 to 6.0%-6.5%, and so we would not expect further aggressive stimulus from the authorities unless they have to defend the lower end of this range.
So while we could see improvement in China – certain purchasing managers’ indices (PMIs) look more promising – we remain cautious on the prospects for companies not exposed to long-term secular trends such as rising consumption. In the IT sector, DRAM (computer memory hardware) prices continue to fall even as firms such as Samsung have seen a rise in share prices year to date. Normally, the two correlate closely, suggesting the market believes the semi-conductor cycle will turn in the second half of this year. If it does not, then EMs may struggle to make headway as big tech companies constitute a significant proportion of the MSCI EM index.
EM Inflation Trends Lower
In addition, we have noticed a downward trend in EM inflation, which raises the question of whether nominal interest rates and risk premia will be lower over the next five years. We have already seen China adjusting to new growth expectations, but there are structural reasons why EMs, while continuing to offer opportunities arising from their development, might produce more DM-like returns in the future.
Inflation across EMs has been trending downwards since 2011 thanks to inflation-targeting, more credible central bank policy and lower energy prices. However, the component drivers of inflation have also changed. Figure 3 shows that the proportion of inflation driven by country-specific components has fallen since 2016 compared to an increase in common inflation components that affect all EM countries. The common component is driven by oil price inflation, while idiosyncratic inflation is falling as economies open up and FX volatility declines.
At present, it is hard to determine if these changes in inflation composition are permanent or not. If they are, this will have implications for long-term expected returns. So far, nominal yields seem to have contracted more than real yields, but the reduced inflation risk premium appears not yet to be fully priced in.Even if overall inflation volatility may be coming down as EMs globalize, many countries remain exposed to national policy choices. So we are likely to continue to see interest rates vary across the asset class. Finally, we recognize that this change in the component drivers of inflation may be a function of where we are in the cycle, rather than an indicator of future returns, and requires further research to determine its significance.
Reasons to Go Active
Any reduction in the inflation risk premium will affect not only rates, but also equity risk premia. EM-type returns should continue to be available given the high level of idiosyncratic risks across the EM universe e.g., around elections, sanctions, policy moves and product cycles. However, returns are likely to be more disparate than before – EMs remain highly heterogeneous in growth terms as evidenced by the manufacturing PMIs in Figure 4 – and require an active approach to achieve them.
If inflation volatility does continue to fall in EMs, currencies should benefit. In the short term, we are seeing attractive currency yields available in places such as South Africa and Mexico. Investors need to be able to assume the higher idiosyncratic risk these markets bear, but in our view a lot of macroeconomic risk is already priced in and the short-term cyclical outlook is positive compared to last year. That said, it can be useful to gain exposure to these areas in an active manner to be able to manage risk dynamically as conditions change.
With the Fed on pause and the US-China trade dispute inching toward resolution, the improving liquidity picture is strengthening our case to be constructive on EMs, while remaining aware of both macro and country-specific risks such as forthcoming elections in India. The US economic expansion is now the longest ever, at 117 months, so the Fed may take its time before it moves on rates, whether up or down, though the US consumption story appears intact for now. More accommodative policy should be positive for EM foreign exchange against the dollar unless EM growth weakens substantially from here. However, EM currencies are generally near fair value and the carry over the dollar is not huge given that dollar yields are relatively high.
In summary, EM headwinds may have faded but tailwinds such as favorable currency conditions have yet to appear. Earnings expectations still need to stabilize and underlying growth fundamentals remain relatively weak. In such a climate, it can be helpful to take active positions and avoid stocks that could suffer the most from macroeconomic and policy shifts.
1 As of 28th February 2019
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