Emerging market (EM) equities have reversed their downward trend. In the last decade, EM equities have underperformed developed market (DM) equities by some 20 per cent and in the last five years the underperformance has been even more pronounced at over 65 per cent (through end of 2015).
However, from mid-January onwards this trend has reversed with gains of 34 per cent versus developed market returns of 18 per cent (from January 20 to August 16). Emerging market bonds have also seen double digit returns this year, be it sovereign or corporates, local or US dollar denominated securities.
With improving fundamentals and earnings revisions, attractive valuations, as well as improving sentiment, emerging market assets, and equities and currencies in particular, have room for further upside over the longer term.
In terms of improving fundamentals, growth differentials between EM and DM have begun to reverse. The IMF, in its World Economic Outlook in April, forecast EM countries to grow 4.9 per cent per year on average between 2017 and 2021, while DM countries are expected to grow only 1.9 per cent on average over the same period.
Many EM countries are making meaningful progress on structural reforms to stimulate growth and earnings. Additionally, prospects of further interest rate cuts by EM central banks bode positively for emerging markets’ growth and assets.
Among EM, the outlook for emerging Asia is particularly bright. Asian countries have enacted encouraging reforms and shown solid increases in their current account balances.
Focusing on select economies, Indonesia has made progress on tax, foreign direct investments (FDI) and energy reforms. The country is showing economic growth, keeping inflation down and its central bank is expected to cut rates further. These improvements in fundamentals now outweigh what has been in the past more a call on US interest rates and the US dollar.
From a valuation perspective the dispersion in EM equities is significant both at the regional and sector level providing opportunities for active managers.
Emerging market equities have rallied this year, though at a headline level valuations are still depressed and remain attractive compared to history and versus those of DM equities. The twelve month price to earnings ratio of EM equities is 12.2x versus 15.8x of developed world equities.
Valuations both on EM equities and currencies are even more compelling considering the higher expectations for future GDP and earnings growth. Additionally, while emerging market equities were inexpensive in the past few years as well, the outlook of future returns looks increasingly positive given that after several years of consistent downgrades, earnings revisions have now started to stabilise and a number of countries are showing positive revisions.
From a positioning perspective, EM assets remain significantly under-owned versus history and developed markets. However, sentiment is starting to improve and flows into EM investment funds are beginning to turn positive particularly as fears around risks to EM economies are starting to fade or have already been reflected in valuations.
However, one must be cognisant that risks to the outlook of emerging markets remain. Federal Reserve expectations have perhaps been pushed out too far and given the level of flows already coming into EM this may mean the asset class is due for a pause of breath.
However, the opportunities in EM are a longer term case and risks have been significantly reduced given several years of adjustments for EM economies and assets.
This year EM currencies have started to stabilise. China has had disappointing macroeconomic data for some time, but it has recently become more stable.
The country is making efforts to move to a consumption driven growth model and should be able to avoid a “hard landing”. The economy can continue to be supported by large fiscal spending and the labour market is holding up despite excessive capacity reduction. Energy markets have been another large risk factor for EM. Now it seems the worst of the commodity down-cycle might be over.
Developed market companies have also spoken selectively about the improvement in EMs. Consumer companies made notable positive comments on improving consumption in Russia while highlighting Brazil as continuing to be challenged.
EM exposed DM companies’ share prices have in general also outperformed this year and across sectors with the mining sector particularly benefiting from the strength in commodities for which EM remains the dominant source of demand.
Emerging markets have already significantly outperformed developed markets this year. All economic sectors and most countries (22 out of 23 EM countries through August 16) have shown positive returns. Despite these robust returns, the performance differential between EM and DM remains wide.
With a positive macroeconomic outlook and attractive valuations, we can still expect a substantial rally in these markets over the longer term.
Rajesh Tanna and Nicholas Roberts are senior portfolio managers at JP Morgan Private Bank and Ilaria Calabresi is a vice president at JP Morgan Private Bank