Following two years of double-digit positive performance, emerging market (EM) equities have reversed course this year. Looking at the drivers of return, it is clear that investor confidence has taken a big hit, with multiples contracting and currencies weakening relative to the U.S. dollar.
Trade tensions have played a big role in souring sentiment towards EM this year, as investors worry about future negative effects on EM economic and earnings growth. This is especially true as the U.S. administration’s focus over the past few months has turned squarely to China, the largest EM economy and major trading partner of many other EM countries. In addition, uncertainties around trade have caused a broad-based rally in the U.S. dollar, as investors have fled riskier assets like EM for the safety of the defensive U.S. market. This dollar strength has raised its own set of worries, as some local central banks have been forced to tighten policy in order to offset inflationary pressures, a further headwind to growth.
What could cause confidence to improve in 2019? A cease-fire between the U.S. and China, involving a roll-back of previously enacted tariffs, would go a long way towards improving confidence. In addition, it will be crucial to see Chinese economic data stabilize. Lastly, as always, EM assets will be sensitive to developments in the U.S. economy, with a “soft landing” next year needed and an end to Federal Reserve tightening welcomed. Should these events materialize, we should see a weakening of the U.S. dollar relative to EM currencies, a scenario in which EM assets tend to do very well.
The 2019 “wish list” for EM investors is long and its fulfillment is hard to predict. As such, it is tough to know what the next 12 months alone will bring. The next few years, however, are a different story. EM valuations have come down 16% this year, making EM equities the cheapest they’ve been in two years in absolute terms and in 15 years relative to U.S. equities. In addition, given its more favorable demographics, EM economies may grow 250 basis points more than the U.S. on an annual basis over the next 10-15 years, translating to much higher revenue growth. Combining low valuations, high revenue growth, and higher dividend yields, EM equities look set to return 325 basis points more than U.S. equities on an annual basis over a 10 to 15 year window (as noted in our 2019 Long-term Capital Market Assumptions). The flight to Shanghai or Rio de Janeiro will be long and bumpy, but the destination will be worth it – and tickets are now on sale.
EM cheapest relative to U.S. in almost 15 years
MSCI Emerging Markets valuations relative to those of the S&P 500
Source: Source: MSCI, Standard & Poor's, FactSet, J.P. Morgan Asset Management.
Price-to-book (P/B) is last twelve months and price-to-earnings (P/E) is next twelve months' actuals.
Data are as of November 21, 2018.