Emerging markets equity: Credit to the Chinese
House View: Q2 2017
- A strong start to the year for emerging market equities
- Corporate earnings continue to recover
- Global politics remains a risk
The recovery in emerging markets has reasserted itself after a pause in Q4 2016. The coincident recovery in global growth and a pick up in inflation have created an attractive backdrop for emerging markets and underlying corporate earnings. The significant valuation discount of emerging markets to developed markets remains excessive, particularly in an environment of resilient near-term growth.
Emerging market equity performance
2016 was a strong year for emerging market equities, as they gained just under 12% on a total return basis in US dollars (Figure 1). After a period of consolidation in equity prices in the fourth quarter, this rally in emerging market equity prices has continued with a further 9% gain to mid-March. As we have highlighted in the past, this positive return should be put in the context of prior years. The MSCI Emerging Markets Index was launched in 1988, and since then the average positive year has returned just over 40%. With this in mind, the question rapidly focuses on the foundations of the recovery and its sustainability. For this we believe we need to look at valuations, the economic backdrop and, finally, politics.
Absolute and relative valuations
We have consistently highlighted that emerging market equities are materially undervalued. Compared to developed market equities since 2014, (and for this we use the MSCI World Index), they have consistently traded at a near 30% discount (Figure 2). The recent recovery in emerging markets has been coincident with a recovery in earnings expectations that has outstripped that of developed markets. This means that an expectation of a reduction in the discount in valuation has not materialized. To put that in context, over the past 6 months expectations for 2017 earnings for developed markets have increased by 7%, while for emerging markets that increase has been 12.5%. Over that same period, developed markets have outperformed emerging markets by 1.3%, further opening up the valuation gap.
The valuation of emerging markets compared to their recent history is perhaps one of the weakest links in this argument. They currently trade on 12 times next year’s earnings. This compares unfavourably with a 10-year average of 11 times and a 5-year average not far off that mark. However, developed markets trade at a 22% premium to their 10-year average. But when we scratch beneath the surface, the picture is very different: developed markets, for example, trade on 16.7 times earnings, have a return on equity of 10.15% and a yield of 2.5%. Emerging markets have a similar but better return on equity of 10.6%, a higher expected yield of 2.7% and still trade on only 12 times earnings.
The earnings expectations for emerging markets (Figure 3), on which all these valuations assumptions are built, remain depressed. To put this in context, we can look at historic earnings for emerging markets. What becomes very clear is that 2016 earnings were less than 10%ahead of those which were achieved in 2009 as the impact of the global financial crisis was felt across all markets. The 15% growth in earnings expected for this year looks comparatively modest compared to the rebound of over 40% we experienced in 2010. Should we take our lead from the ever-moving feast of analyst forecasts, clearly expectations for emerging market earnings are rising. This should be highly supportive of sentiment, valuations and, of course, equity prices.
The improvement in expectations and corporate earnings across emerging markets is clearly supported by an improvement in the economic backdrop. Countries such as Brazil and Russia, both of which experienced significant recessions over the past two years, have passed an inflection point. More important though is the clear change of priority in China. In the lead up to the Chinese domestic equity market correction in 2015 there was a focus on reform. This was embodied in the anticorruption push and targeted reductions in capacity and consolidation across the iron ore, coal and steel sectors. The cost of this, combined with the deceleration in credit growth, was, in our view, an unreported slowdown in GDP. In early 2016 growth clearly became the priority, credit growth re-accelerated and both property and infrastructure projects were rapidly approved. The Li Keqiang index (Figure 4), often derided as measuring only the historic drivers of Chinese economic activity, subsequently re-accelerated and has remained strong, suggesting that Chinese growth could even be running faster than the fastidiously reported 6.5% to 7% target range.
The importance of China and the strength of its growth cannot be under-estimated for emerging markets. Commodity prices have recovered strongly as Chinese demand has increased. This recovery in Chinese demand, combined with historically-loose global monetary policy, has been rapidly transmitted through to corporates in emerging markets. It is no coincidence that the emerging market Markit PMI (Figure 5), a measure of the health of the manufacturing sector, has recovered dramatically from the lows in late 2015 and early 2016.
We cannot mention China and the strength of its economic recovery without highlighting the over-hanging risk associated with its excessive and sustained credit growth. However, in the near term this should not detract from their positive contribution to growth. In our view, China’s near closed capital account and the upcoming national party congress in the fourth quarter makes this a mid – rather than short-term risk to emerging market equities. We therefore believe investors should be aware of the risks but still take advantage of the current strong support to earnings growth that Chinese policies provide in the near term.
The political backdrop for emerging markets is perhaps the aspect that has received most attention recently. While there are still specific issues with domestic politics in some emerging markets, these are outweighed by those major players - China, Brazil and India - where the news is more positive.
Unusually of more concern is the impact of developed market politics (Figure 6). While the uncertainties around upcoming European elections are unlikely to have any more lasting impact in emerging markets than the initial reaction to the Brexit vote, the US is more of an issue.
The potential destabilising effect of an introduction of trade tariffs and the cancellation or renegotiation of agreements such as NAFTA remains a concern, though one that we hope will be tempered by the knowledge that the integrated nature of global supply chains means punitive tariffs would not leave the US unscathed.
The strong start to 2017 for emerging market equities has the foundations to continue in the near term. Corporate earnings are benefiting from a recovery in global growth. We remain concerned over the sustainability of Chinese credit growth but acknowledge that the authorities’ policies are highly supportive of both Chinese and emerging market growth. Valuations remain excessively cheap in both absolute and relative terms. While emerging markets behave, the main risk has now become the unpredicatable political backdrop in developed markets.
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