Emerging Market Strategy Q2 2018: Internal strength, external risks
- Fundamentals are strong for emerging market (EM) equities, and valuations are neutral.
- Risks to the asset class are primarily external, not internal. They include: late-cycle complications in developed markets, the unwinding of quantitative easing and trade skirmishes amid a rebalancing and slowing Chinese economy.
- Disinflationary output gaps are closing in developed markets, but EM economies are still early cycle using similar measures.
- As global growth stabilizes at healthy levels, our sector rotation signals are beginning to turn away from cyclicality and toward defensive sectors.
Risks to an asset class come in two varieties—internal and external. In past cycles, the main risks to emerging markets came from within (overheating economies, FX peg regimes amid external deficits and hard currency-denominated sovereign debt, among others). But as we assess the prospect for EM equities, the risks today appear to be primarily external, not internal.
The asset class faces those risks from a position of relative strength. Fundamentals are strong, with self-reinforcing economic growth and rising profits; valuations, while no longer cheap, remain quite reasonable. The external risks include potential late-cycle complications (for example, inflation pressures and monetary tightening) in developed markets; the impact of a quantitative easing (QE) unwind (and associated bond re-rating impacts on global equity valuations), and trade skirmishing amid a Chinese economy that is slowing and rebalancing. We address these issues below, concluding, as always, with some actionable investment ideas.
Earnings growth and output gaps
Over the course of 2017, earnings growth propelled emerging market Asia Pacific (EMAP) equity performance, and that trend has continued in 2018. When the rally began in early 2016, valuations were quite cheap. Today we find them in the neighborhood of neutral, with price-to- book ratios at 1.75–1.8x, in line with the 20-year average. Using cyclically adjusted P/Es (current price over the 10-year average earnings), emerging market multiples (18.5x) remain below their own long-term average, have only just caught up with European equities (18.8x) and remain well below those in the U.S. (at 30.0x).
EM equity valuations range from neutral to modestly cheap
EXHIBIT 1A: EM PRICE-TO-BOOK RATIO
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