What is the investment outlook for emerging markets? Could the chronic underperformance of emerging market equities of the last six years be coming to an end?
There are reasons to be optimistic, in our view
The potential for earnings growth in emerging markets is significantly greater than it is for developed markets. Margins in the US and Japan are near historic highs and declining, and at average levels in Europe, while they are close to historic lows and rising in emerging markets (see Exhibit 1). Even without any increase in revenue growth, emerging market corporations can generate greater profits simply by returning to normal levels of productivity. This potential is being translated into earnings expectations that are currently rising faster for emerging market companies than for developed market companies.
Exhibit 1: Forecasts for net margins in emerging and developed markets indicate to us that the potential for earnings growth is greater in emerging than in developed markets
Sources: Factset, BNP Paribas Investment Partners as at 24 August 2016.
Valuations also support the case for emerging markets, with relative valuations on both a P/E and P/B basis below their historical averages. Much of the gain over the last few months has been driven by the recovery in oil and commodity prices and the more recent weakness in both could in turn translate into another downturn. We believe commodity prices will stabilise near their current levels, which should minimise the shocks that commodity price volatility sends across emerging market economies. The recovery in earnings is crucially spreading beyond the commodity sectors, notably into consumer discretionary and technology. Finally, growth in China appears to be stable if not improving, with the latest PMIs for both services and manufacturing above 50, and rising for the latter.
There are of course still risks to emerging market equities
If the Fed raises rates sooner or by more than markets expect, a subsequently rising US dollar will prompt further fund flows out of emerging markets and exacerbate already existing problems faced by companies with US-dollar debt. Political risk is ever-present. But the combination of more stable currencies and commodity prices, as well as low margins and valuations, argue for increased allocations, particularly in domestic demand- (as opposed to trade-) sensitive sectors.
The hunt for yield is driving investors ever further into emerging markets, where the attraction of spreads of 300bp-650bp over US Treasuries is obvious. The most attractive part of the market is US dollar-denominated sovereign debt, where spreads are at the higher end of the range they have been in during the QE-era, though still well below previous peaks (see Exhibit 2).
Exhibit 2: Analysis of emerging market debt spreads for different categories of emerging market debt
- EMBI = Emerging Market Bond Index.
- CEMBI = Corporate Emerging Market Bond Index.
- GBI-EM = Global Bond Index – Emerging Markets.
- Black line shows range from minimum to maximum since January 2009.
- Blue boxes indicated 25th to 75th percentiles. Diamond shows latest value.
Sources: J.P. Morgan, BNP Paribas Investment Partners as at 24 August 2016.
Spreads on corporate debt issued in US dollars by emerging market companies are not as high comparatively, and also much further below the extreme levels they have reached in the past – nearly 1 000bp. Given that these companies are having to make payments in dollars with currencies that have depreciated by over 30% since 2011, it is not clear whether the current spreads are adequate. Sovereign debt looks to be the better option within the US dollar realm.
Local currency government debt offers even more attractive yields, although these are lower than normal, and along with the higher yields comes higher currency risk. The main trigger that might spur another decline in emerging market currencies would be aggressive Fed tightening, but based on recent economic data, that seems unlikely. In fact, a more dovish Fed gives some emerging market central banks scope to cut their own interest rates, which should boost price returns for government debt. The significant pickup in yields on offer from local currency emerging market government debt compared to US Treasuries means it will justifiably remain an attractive asset class for investors.
Expected returns for publicly-traded assets remain low and investors are left to choose the best options they can find among a not particularly attractive set of options. Equities should recover their poise vis-à-vis bonds through the rest of the year, although shocks will inevitably occur and there will likely be periods of underperformance, albeit quickly recuperated. As central banks persist in their bond-buying policies, income will remain a key determinant of investor decisions. Higher-yielding equities should be supported by robust demand, but investors ought to consider whether the marginal advantage in dividend income warrants the premium they pay. In our view, they might look to sectors and markets with a more promising growth outlook, from technology to emerging markets, that will pay “dividends” over the medium term.
With economic growth broadly stable, a significant increase in credit spreads is unlikely, making high yield and emerging market debt appealing. Among the investment grade options, US and Asian credits look more interesting than those in Europe. Thanks to the ECB’s bond buying programme, yields on corporate bonds in Europe are over 200bp lower than those in the US. While yields could fall further, and those in the US may rise, the additional spread should carry investors through.
Profitable buy-and-hold strategies will nonetheless remain challenging to find. Investors should look to more actively managed funds that take can advantage of frequent volatility spikes to move in and out of beaten down or overvalued assets. [divider] [/divider]
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk. [divider] [/divider]
This article was written by Daniel Morris, Senior Investment Strategist, on 24 August 2016 in London
This article is part of our recent ‘Investment outlook’ and ‘Economic outlook’ series.
Here are the links to all the articles: