By Lauren Juliff
So far, 2016 has been a much better year for emerging markets; the MSCI EM index has, year-to-date, delivered very positive returns for GBP investors and the benchmark is ahead of its developed market equivalent by 7.4%. This rebound has been underpinned by currency strength as commodity and energy markets have stabilised following concerns over China at the start of the year and dollar weakness on reduced expectations of US interest rate rises.
After the disappointment of the past few years, investors are naturally cautious as to whether the latest EM rally could be another false dawn or the start of a more meaningful recovery. But if recent signs are anything to go by, the time may be right to seek or increase emerging market exposure.
There has certainly been a shift in investor sentiment, demonstrated by recent inflow into EM equity funds, which has accelerated following the UK referendum. July saw the highest weekly inflow since January 2013 and there has been net EM equity fund inflow year-to-date following three years of outflows totaling USD96bn.
Inflection point
Recent evidence shows a number of macro and market factors which could be supportive for EM companies. This revival may well be fragile initially but a period of respite from the significant pressures many emerging markets have had to endure should create a firmer platform for positive earnings momentum, allowing a greater focus on fundamentals to differentiate between companies.
According to the IMF[1], emerging market economies are forecast to grow 4.1% this year and 4.6% in 2017. Although these estimates are at the lower end of recent levels, they are still more than double the equivalent figures for advanced economies, which were recently revised downwards following the UK referendum. These figures could represent more realistic and sustainable levels of EM growth. Maintaining economic estimates or upward revisions to GDP forecasts would be a positive signal for a continued emerging market recovery.
The weakening of the US dollar has also seen a reversal of the significant headwinds faced by many emerging markets. Over the past five years, EM currencies fell by over 30%[2]. Despite the recent rally, they remain well below historic levels with significant scope to strengthen (see chart) and may be further helped by the reduced prospect of a US interest rate rise in the wake of Brexit. This potentially opens the door to greater capital in-flows into EM which would make foreign debt easier to service, thus boosting company and equity performance.
Earnings momentum key
The key catalyst for a sustainable recovery in EM equities will be increasing earnings expectations. EPS estimates were revised upwards in the second quarter of this year for the first time in 12 months and earnings are currently forecast to grow in 2016 and 2017 following declines in the past two years. Investors should therefore monitor earnings expectations closely with further positive revisions likely to add momentum to the EM recovery.
Another important feature of the recovery for EM equity investors is valuation multiples. Higher earnings estimates mean that stocks remain attractively valued on a P/E basis; at 13.2x they are broadly in-line with the EM historic average multiple and well below developed markets at 16.8x. Perhaps more telling is the MSCI EM P/B multiple which recently rose above 1.4x for the first time in 12 months, a level only previously seen on four occasions in the past twenty years; the Asian crisis, 9/11, the Gulf War and the Financial crisis (see chart). Each of these periods was followed by strong equity performance, with three-year annualised returns averaging 29%[3].
But, be selective
With such compelling valuations it could be tempting to think that any EM equity exposure will reap rewards but countries often have wildly different levels of GDP growth and productivity, meaning that it is dangerous to treat EM as a single asset class with a uniform risk-reward profile. There is similarly huge diversity between companies and their fundamental strengths, which argues for a selective investment approach to achieve the best risk-adjusted returns.
With emerging market economies still growing at 3-5% and valuations at attractive levels despite the recent bounce, the current environment should represent a good time for long-term investors to seek or build EM exposure. If currency markets remain supportive and earnings momentum continues, shareholders in the strongest companies could well be in for a sustained period of attractive returns.
Lauren Juliff is head of UK institutional at Skagen Funds
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[1] IMF World Economic Outlook Update, July 2016: https://www.imf.org/external/pubs/ft/weo/2016/update/02/pdf/0716.pdf
[2] As at end June 2016
[3] Source: MSCI
