After trailing developed and, in particular, U.S. equities for several consecutive years, emerging markets equities (as measured by the MSCI Emerging Markets Index) have staged an impressive rally since 2016. At the start of this year, expectations were that this recovery would continue over the coming years given the backdrop of stronger economic and corporate fundamentals. However, April brought a rather unexpected (temporary?) turning point, as emerging markets reversed into a period of underperformance. So what to expect from here?
After a few years of strong performance, a number of headwinds buffeted the emerging markets rally in the second quarter. The combined impact of a less synchronized global growth trend (despite continued strong US growth), together with economic and geopolitical initiatives from the Trump administration (US tax cuts, sanctions on Russia and Iran, trade frictions with its main trading partners) led to expectations of stronger US interest rates, oil price volatility and a strengthening US dollar.
As a result, several emerging markets and their currencies, especially those with some weaker fundamental external positions, have started to come under pressure over the last few weeks. With 2018 being an important election year in emerging markets, political newsflow from Turkey, Mexico, Brazil, Malaysia etc. has added to uncertainty. The recent Italian political situation did not help to bolster sentiment either, especially in Eastern European markets. During this period, larger emerging markets with stronger fundamentals, such as China, South Korea, Taiwan, have nevertheless continued to show decent performance. However, it is no surprise that some investors question the prospects for emerging markets as an asset class. While we recognise that these issues have increased overall market volatility, and idiosyncratic country, sector and stock selection will remain important, several factors support our relative optimism for emerging markets in the mid to longer term.
Favorable economic conditions and earnings growth are key determinants of equity returns. As we navigate a new market cycle, EM equity returns are expected to benefit from secular demographic trends, lower corporate debt levels, and stronger intra-EM trade. Also, while the US dollar remains an important driver, the debt level in USD of EM-listed companies, especially those in Asia, has been reduced since the crisis of 2013, thanks to deleveraging and capex discipline.
According to MSCI, earnings and revenue growth for EM equities are expected to outpace foreign developed markets well into 2019. Candriam estimates the strongest earnings growth will come from Asia (primarily China and South Korea), and within the following sectors: information technology, materials, and energy.
Further supporting the case for EM equities are attractive valuations relative to both historical averages and to developed markets (as measured by CAPE (cyclically-adjusted price-to-earnings ratio).
(It is not possible to invest in an index. Past performance is no guarantee of future results.)
For several years, the risks, rather than the opportunities, of investing in EM equities dominated headlines and investor sentiment. However, as we reached an inflection point in 2016, prospects for emerging markets investing have clearly improved.
Despite the promising outlook, investors need to be mindful of the risks associated with emerging markets, and asset selection remains key for (out)performance. There are still central bank policy and geopolitical risks, including protectionism and trade tariffs. Candriam remains vigilant on global and local macro-economic trends, regulatory reforms and (geo)political developments, as well as stock selection, as per Candriam’s bottom-up approach. At the company level, fundamental stock selection with the flexibility to exploit market inefficiencies and manage risk is, and will remain, increasingly important. Candriam believes investors can achieve greater success through a thematic approach that favors quality companies with competitive advantages and strong, sustainable organic growth.