Emerging market equities have outperformed developed markets thanks to strong earnings growth.
Economic reforms, improving corporate fundamentals and reasonable valuations support EM stocks. Reflation and growth in the developed world are other positives. Risks include sharp changes in currency, trade or other policies.
EM Asia’s economic backdrop is particularly encouraging. China’s economic growth and corporate earnings outlook look solid in the near term. We like India, China and selected Southeast Asian markets.
Emerging market (EM) equities have outperformed developed market (DM) equities so far this year, ending a five-year slump of underperformance (see Figure 1). We see global factors supporting EM assets and local factors supporting a bias towards Asia.
- Global factors: Global growth is currently in a steady, synchronized, above-trend regime – a view reinforced by the BlackRock Growth GPS. Our analysis shows EM economic activity’s beta to DM rises during these regimes.1
- Local factors: A regional bias is warranted in our view due to currently attractive valuations, positive economic reforms, improving corporate fundamentals, strong external positions and greater exposure to technology.
Figure 1: Earnings are driving the global equity rally
Source: Thomson Reuters. BlackRock Investment Institute. Oct 3, 2017. Indexes shown are the MSCI Emerging Markets Index, MSCI Asia ex Japan Index, MSCI All Country World Index, MSCI USA Index, MSCI Eurozone Index, MSCI Japan Index, and MSCI UK Index. Multiple expansion refers to increases in the price to earnings ratio. The EPS growth rate is calculated as the year to date percent change in earnings per share. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Attractive valuations only half the story
As of October 2, the MSCI Emerging Markets Index traded at a 24% discount to the MSCI World Index based on 12-month forward P/E ratios (12.6 vs. 16.6). Although EM tends to trade at a discount to DM, this valuation gap has historically closed when the EM-DM GDP growth differential widened. That may be the case now and suggests EM equity multiples may rise towards DM levels. Stronger EM GDP growth may translate into stronger corporate earnings growth.
EM earnings growth has outpaced major indexes this year, as shown in Figure 1. Using Thomson Reuters I/B/E/S data as of October 3, analysts currently estimate the MSCI EM Asia Index’s earnings will grow another 20% over the next 12 months. The breadth of the EM recovery reflects the breadth of global growth at the moment, in our view. We favor a regional bias towards EM Asia due to the mix of local economic reform efforts in China and India, improving corporate fundamentals (improving margins, revenue and earnings growth), greater exposure to technology (via China, Taiwan, and South Korea), and strong external positions.
Climbing the wall of worry
EM equity has broadly outperformed expectations this year, in part due to a larger tech exposure. The MSCI EM Asia Index has a 37% tech weight while the S&P 500 has just 24%. Some local factors are also worth highlighting. The market expected economic reforms in China and India to slow near-term growth, yet growth has been robust. In China, the supply side capacity cuts have lifted margins and industrial profits. In India, manufacturing PMI data are already signaling a renewed expansion after the goods and services tax, implemented on July 1, dampened activity. Figure 2 shows EM Asia economic data are surprising on the upside, leading earnings forecasts higher. For example, the MSCI China Index 12-month forward earnings growth estimates currently sit at 20% year-over-year, having accelerated 4% in just six months.
EM equities have become more popular this year – but not too popular. Our EM equity ‘crowded’ indicator – which combines flows, positioning, and price momentum – shows investor positioning is currently well balanced. In fact, Figure 3 shows ‘crowded’ short positions in EM equities throughout most of 2016. This year’s increase has merely brought market positioning back to historically average levels.
Figure 2: Better data, better earnings
Figure 3: EM equity positioning currently
Source: I/B/E/S, Citi, Thomson Reuters. Sept 29, 2017. Earnings estimates are for the MSCI Emerging Markets Asia Index. Indexes are unmanaged and one cannot invest directly in an index. The Citigroup Economic Surprise Index measures economic data releases against consensus estimates. Positive (negative) values indicate economic data is better (worst) than expected.
Source: BlackRock RQA. Sept 29, 2017. The Crowded Macro Positions indicator combines institutional, fund, and ETP flows, internal and external portfolio positioning, and price momentum into a composite score which is normalized using a z-score calculation. A value above (below) zero means the composite score is above (below) the 2-year rolling average.
Factors such as relatively attractive valuations and strong, broad-based global growth can support EM equities, in our view. EM Asia looks well positioned for a variety of reasons: a 24% valuation discount to DM peers4, robust earnings growth, positive reforms, improving economic growth and greater exposure to long-term growth opportunities in tech. With positioning balanced and a solid fundamental backdrop, investors may want to take a closer look at equities in EM Asia.
This was originally posted on iShares.com
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.