2015 was an underwhelming year for emerging market equities. There was wide dispersion between the returns of individual markets, with relative strength in India, positive returns from Eastern Europe and marked weakness in Latin America.
China began 2015 with an extraordinary rally in its domestic markets, generating positive sentiment for the emerging market universe as a whole.
The subsequent sharp correction in Chinese equities led to widespread volatility and increased risk aversion worldwide. The first week of 2016 saw renewed volatility in global stocks, triggered by China.
As fears of a ‘hard landing’ in China have grown, both commodity prices and emerging market currencies have weakened. Downward earnings revisions were widespread in 2015 and share prices slumped.
With the US leading the developed world in terms of growth, concerns about an increase in US interest rates were a dominant theme in 2015.
In this Q & A, the chief and deputy investment officers of our Boston-based Global Emerging and Frontier Markets Equity team review 2015 and set out the prospects for emerging market equities in 2016.
What are expected to be the three key factors driving returns in this asset class
1. Earnings growth and the pace of global GDP growth
2. The potential for self-help and reform in the emerging markets
3. The policy direction of the developed world’s central banks – and its impact on foreign-exchange rates, economic growth and commodity prices.
How do you expect these drivers to evolve? What do you expect the likely impact on the asset class to be?
Forecasts for headline earnings growth in emerging markets are currently in the low double digits. But given the trend of subdued global growth, we expect forecasts to be revised down over the first half of 2016. Should global growth stabilise, however, we expect emerging market companies to benefit from any pick-up in economic activity. Meanwhile, many of the headwinds that affected the emerging market asset class in 2015 are in our view now behind us – including dramatic drops in currencies and commodity prices. We do not necessarily expect reversals of these trends to provide tailwinds in 2016, but we do expect a neutral effect rather than a negative one.
We see the potential for some emerging markets to benefit from efforts to reform their economies. In the past year, we have seen a number of positive developments in India, for example. Although expectations were set too high for the Modi government’s measures to improve transparency and economic growth in 2015, we continue to look for positive changes in the year ahead. We are also seeing structural improvements in Mexico, which are conducive to better earnings for companies operating there. We have seen a divergence in performance between countries that are making progress in implementing reforms and those that are not and anticipate this trend to continue in 2016.
The policy direction taken by developed world central banks is likely to continue to influence the performance of emerging market equities in the first half of 2016. Central bank policy may well be slow to normalise, given the fragility of global economic growth. We expect, however, that now the first US rate rise is out of the way, markets will begin to refocus on company fundamentals rather than central bank actions. The key issue is clarity. Once that materialises, we believe many of the anxieties that have beset global markets are likely to subside.
Beyond these macroeconomic factors, we believe the declining correlations between equities in emerging markets can be an increasingly important driver for the asset class as investors differentiate between markets according to their economic fundamentals. There is an increasing recognition in the market of the growth and quality of earnings of individual companies, which is resulting in a greater degree of performance disparity between securities. This favours fundamentally-based approaches such as ours. In our research and governance-oriented stock selection process, we focus on company earnings and cash flow growth and aim to benefit from the growing dispersion of returns.
How do current valuations compare with 3-year or 5-year averages or with other relevant asset classes?
Current valuations for emerging market equities are attractive, being below both their 3-year and 5-year averages, though not markedly so (see Exhibit 1 below). There is also a wide valuation gap between emerging market and developed market equities. That, of course, is on aggregate. At the stock level, there are many attractive valuation opportunities to be found – especially in mid-capitalisation and small-capitalisation stocks, where inefficiencies are greater and there is less analyst coverage.
Is valuation a compelling reason to favour the asset class?
Valuations have become more attractive over the past year, but are not yet extraordinarily compelling by historical standards. The reason for this is that while share prices have fallen, earnings have been revised down markedly. There are regional variations, however. As earnings have held up better in Asia than in other emerging markets, Asian valuations do look more compelling on aggregate (see Exhibit 2). In contrast, Latin America looks relatively expensive. This is somewhat surprising, given the steep underperformance of the region’s equity markets in recent years. It is largely explained by sharp downward earnings revisions for commodity heavyweights such as Petrobras and Vale. Latin American markets do look more attractive on price-to-book measures (see Exhibit 3). This also holds true for Asia and emerging markets in general.
Exhibit 1: The forward price-to-earnings ratio (P/E) for the MSCI Emerging Markets index is below the historical average
Exhibit 2: The forward price-to-earnings ratio (P/E) for the MSCI Emerging Markets Asia index is near one standard deviation below the historical average
Exhibit 3: The price-to-book ratio for the MSCI Emerging Markets Latin America index is near one standard deviation below the historical average
What are the upside and downside risks for the asset class?
The main upside risk is a faster-than-expected recovery in global economic growth. This would have to be broad-based, rather than the 2015 scenario in which growth was bifurcated and led by the US. A reacceleration in China’s pace of GDP growth would provide support for the commodity complex and for global trade, particularly in Asia. Should China succeed in avoiding a “hard landing”, we could see an acceleration in earnings growth, with upward revisions and increasingly compelling valuations. If inflation remains low even as growth accelerates, the pressure on central banks to tighten monetary policy would remain subdued.
The primary downside risks for emerging markets lie in the three drivers we identified earlier: earnings growth and global GDP growth; self-help and reform; and central bank action in the developed world. Disappointments in growth and earnings would in essence entail a continuation of the environment that we saw in 2015, with the US leading global growth – resulting in a stronger US dollar and encouraging the US Federal Reserve to move toward interest-rate normalisation. This would have negative consequences for emerging markets, which would have to contend with slower global trade and growth disappointments. A lack of reform with regard to pressing issues would be a further negative. Beyond that, inflation is always a risk in emerging markets, but with inflation very low worldwide and excess capacity (or output gap), we don’t see that as an imminent threat in 2016. Low inflation should help to underpin the value in emerging market equities.
Whether macroeconomic developments prove favourable or otherwise, we will continue to focus on industries and market segments with strong and specific drivers of growth, rather than on those that are cyclical or dependent on a rebound in commodity prices. Our objective is to hone in on unique opportunities in a world in which headline growth may prove elusive. In this regard, we see particularly bright prospects for select companies in the health care, consumer discretionary and financials sectors in 2016. Health care should continue to benefit from the strong secular growth drivers of increasing penetration, demographics and a broadening health awareness among the emerging middle class. In consumer-driven sectors, low inflation should support household incomes across many emerging markets. In the financials sector, lower inflation should encourage further accommodative monetary policies and, hence, higher returns.
Our belief is that small and mid-capitalisation stocks continue to offer outstanding growth potential. This segment of the emerging market universe is typically less efficient, has greater growth opportunities and fewer state-owned enterprises. A lower degree of scrutiny and efficiency has obvious benefits for fundamental investors with both wide local knowledge and the appetite and skills for in-depth company research.