Emerging Markets Strategy 2Q 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.
EARNING GROWTHS 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-tobook ratios at 1.75–1.8x, in line with the 20-year average. Using cyclically adjusted price-toearnings (P/E) (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
EXHIBIT 1B: EM FORWARD P/E VS. EQUITY-WEIGHTED SOVEREIGN YIELD
Another way to consider EM equity valuation is to compare the yield spread between equity and sovereign debt. Looking at the earnings yield on the EM equity market (inverting theforward P/E) vs. an equity-weighted measure of sovereign debt (EXHIBIT 1), we see that EM equity valuations remain attractive despite the backup in bond yields. Earnings globally have benefited from a backdrop of healthy and accelerating global growth,which has had the effect of “speeding up” the business cycle. In recent months, the acceleration has faded, but it leaves open one question: Where are we now in the business cycle in developed market (DM) and EM economies? Our preferred approach is to examine output gaps to answer that question.
Breadth is improving at the country level
EXHIBIT 2: GDP GAPS BY REGION AND COUNTRY
EXHIBIT 2 illustrates that output gaps have closed in developed markets as their economies have crossed over from early-cycle disinflationary slack into late cycle, where potential complications could include inflation and faster than expected monetary tightening. In emerging markets, however, disinflationary output gaps have not yet closed, and given current growth expectations they are not anticipated to do so until the end of 2019. Simply put, DM economies have segued into the second half of their business cycle while the EM world remains in the first half of its business cycle. If emerging markets are still in early cycle, does this mean that earnings growth can keep driving equity performance?
Output gaps and our aggregate analyst projections imply favorable RoE trajectory
EXHIBIT 3: EM OUTPUT GAP AND ENSUING CHANGE IN ROE
If emerging markets are still in early cycle, does this mean that earnings growth can keep driving equity performance?
EXHIBIT 3 presents a top-down framework for addressing this issue. It plots historical EM output gaps (on the x-axis) against the subsequent three-year change in return on equity (RoE) (y-axis). The current EM output gap, around -0.50%, implies positive expansion in RoE over the next three years as output gaps revert to (or through) normal. Notably, that is consistent with the bottom-up perspective of our own analysts, who in aggregate expect low-double-digit earnings growth over the next three years, in part reflecting cyclical catch-up.
EXTERNAL RISKS: QE UNWIND, TRADE AND CHINA
While fundamentals are quite strong and internal risks remain subdued, the external risks are undeniable.
We turn first to central bank balance sheet normalization in the G-4 economies and the related rise in bond yields, which presents an additional external risk to EM equities. Over the past 20 years, when emerging markets ran into trouble in periods of rising U.S. rates, two factors were observed: Real interest rates were positive and rising, and the EM economies were already overheating. In other words, they were cyclically vulnerable in their own right to the impact of higher real U.S. rates. Today we see neither factor yet in play: U.S. real policy rates, while rising, are still negative, and EM economies are some distance from overheating.
Regarding recent trade skirmishes and China, a bit of background is helpful. As major DM policymakers advised (if not demanded) a decade ago, the Chinese economy has been rebalancing, shifting from an investment-led, industrial-centric model to a consumption-led, services-based model. Recently, as Chinese policymakers have tightened credit conditions, the consumption boom that was spurring that rotation has begun to wane. In the past few months, for example, growth in both retail and auto sales have slowed to the single digits. Additionally, segments of public sector investment growth have slowed while private sector investment has sustained moderate growth. The result: China’s nominal GDP (and almost each segment therein) is growing at a single-digit pace.
From the perspective of China’s major trading partners, there’s an element of “be careful what you wish for.” Secular rebalancing has shifted domestic demand from importintensive investment toward import-light consumption. Ironically, the fact that China abided that earlier rebalancing “recommendation” has constrained import demand and complicated efforts to prevent recent skirmishes from devolving into a full-blown trade war.
Finally, we close with some observations about what is happening within EMAP markets, beginning with sector rotation. As global earnings estimate revisions approach prior peaks in aggregate terms (and have reached their peaks in breadth), and global policy rates move upward, led by the U.S., our sector rotation signals are beginning to suggest a turn from cyclical to defensive stocks. However, as we look across sectors, information technology stocks do not appear overvalued and financials are still favored. As a result, we are only selectively rotating away from cyclical sectors.
On the currency front, we continue to believe that the U.S. dollar is in year two of a multi-year retracement cycle. The U.S. dollar has moved from a peak of about 16% rich to about 4% rich, while most EMAP currencies are leaning modestly cheap. The Philippine peso and Egyptian pound appear quite cheap (the Egyptian currency has also benefited from favorable terms-of-trade impacts from the rally in spot oil prices). Among fundamentally high-risk countries, ongoing political concerns have recently pushed the Turkish lira down toward very cheap levels (the same now appears true of Turkey’s local equity market).
At the country level, where we tactically seek combinations of attractive valuations and positive momentum, we continue to favor Korea and Eastern European markets. Within Asia Pacific,
Japan looks quite attractive, with good economic momentum and valuations that are decidedly normal (by global standards) after two decades of appearing expensive.
Throughout 2017, we enjoyed the so-called Goldilocks story of synchronized global growth and limited inflation. As we have emphasized, the internal risks to EM equity performance are largely contained (and not systemic) amid lingering economic slack, good momentum and reasonable valuations. But external risks—the global business cycle (namely, late-cycle risks in developed markets), the repricing of bonds and its potential impact on equity valuations, and, finally, trade skirmishes—do warrant attention, as they could rebound back on emerging markets. Yet with favorable fundamentals and neutral valuations, the asset class faces those risks from a position of relative strength, and as a result we continue to be constructive.