Economic growth projections for emerging markets (EM) are finally starting to show signs of restoration from modest levels – having bottomed in Q2 of this year – and the ensuing rebound has steadily been translating into more positive earnings expectations after a lengthy period of net downward revisions. The early signs of a breakout from these negative ranges have been encouraging although the breadth of the breakout is likely to be a slow burn process.
By and large earnings revisions are currently concentrated in commodity-related sectors like energy and materials. That said, information technology has begun to see upward revisions and the financials and utilities sectors are starting to see a stabilisation in earnings expectations too, with neither sector joined at the hip to the commodities story. A similar broadening out is taking place at a country level too, with Hungary, Korea and Thailand (countries less influenced by the commodities outlook) seeing upward revisions.
Similar to earnings expectations, reported earnings are no longer falling or correcting as sharply, and there’s a much better balance when it comes to earnings surprises, with the number of positive earnings surprises increasing (a notable change from several quarters ago). And, in addition to top lines improving, bottom lines are also improving where, in some cases, top lines may be lacklustre. Russia and India are good examples of this trend where earnings realizations are often beating expectations in the absence of positive revenue surprises.
Our cash flow analysis shows (in the chart below) that in a world where margins have been pushed down over the past few years owing to commodity pressures, the EM space (ex-commodity) has made good progress over the past couple of quarters, moving slightly off the bottom. And it’s a similar story for EM (incl. commodities) where we’re seeing an improvement in profit margins following a bottoming out.
So how might the turn we’ve seen in both profit margins from cyclical lows and reported earnings influence the earnings growth trajectory from here?
Our forecasts suggest that most ROEs will be higher three years from now (assuming a more normal earnings cycle) but what’s striking is that the biggest earnings rebound is expected to take place in the ‘cyclically depressed’ material and energy sector, although we think it premature for investors to become uber bulls on commodities. As shown in the right hand chart above, the ROE remains at the low end compared to other sectors so investors would do well to err on the side of caution with respect to the rebound.
When we aggregate the numbers across sectors we get a normal ROE that’s close to 14pc, a figure that’s very close to the long term average profitability level in EM. And, while current asset class valuations are not as cheap as they were at the start of this year when the P/B ratio bottomed at 1.2x, the asset class remains moderately cheap relative to historical averages.
Tactical views
We still favour North Asia, particularly Korea, which currently offers an attractive combination of value and momentum. Russia bears similar characteristics; it has been a good performer YTD but appears to still have a lot of value to offer. We’d also place China among this basket of countries but are mindful that as the ‘old economy’ has de-rated and ‘new economy’ re-rated, it no longer looks as cheap as it did a couple of years back when valuations were dominated by cheaper multiple names reflective of the old economy.
Although Mexico’s market still looks expensive we’ve tactically been seeking out beneficiaries of a Mexican peso rebound, when the peso has fallen out of bed, and have opportunistically been accumulating some Mexican names.
Eastern Europe still looks like good value but offers limited momentum whereas this year’s star EM performer, Brazil, is fast becoming a pure momentum play. Where momentum has improved dramatically in Brazil, valuations haven’t been cheap, which is why we have preferred tilting towards Russia which offers better valuation levels and similar momentum characteristics.
Investors are generally starting to see a better combination of value and momentum across the board and EPS growth is adding to performance. Taken together, this could be the key which unlocks a re-rating for the emerging market and Asia pacific region which has been observed in other global equity quarters and why we remain cautiously optimistic on the EM turn.
George Iwanicki is a global macro strategist within the emerging markets and Asia Pacific equities team at JP Morgan Asset Management
