Cautiously optimistic on emerging market equities

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  Morgane Delledonne 
  ETF Investment Strategist



Key takeaways

  • The pullback in EM equities seems overdone and equity valuations look attractive
  • Unlike US equities, EM equities have been discounted for trade war risks
  • Uncertainties remain and require a selective approach for opportunistic buyers

Rising interest rates in the US combined with the escalation in trade tensions has led to risk-off sentiment towards emerging markets (EM) assets since January, and EM currencies have been under pressure despite central banks’ interventions. The MSCI Emerging Market Index has lost 10.5% year-to-date, and 18.5% since its peak at the end of January.

ETF flows suggest low contagion risk within EM

We see low contagion risk from economically challenged economies, such as Turkey, Argentina and Brazil, to the rest of the complex through the lens of global ETFs flows. This was highlighted by minimal net outflows and large net inflows to several EM countries year-to-date, notably into China and South Korea focused ETFs, reflecting possible dip-buying strategies. Another example was when Turkey’s sovereign credit rating was downgraded by both S&P Global Ratings and Moody’s in September on the back of the weaker lira, rising inflation and a large current-account deficit. EM bonds fell across the board, but EM bond ETFs recorded modest net outflows over the week of the announcement, suggesting investors saw little contagion risk from Turkey to the rest of EM.

The pullback in EM equities may be overdone

While US equities continue to rally, the sell-off in EM and European equities suggests market participants have partly priced in the risk of a trade war outside US markets. However, the slowdown in EM economic activity in the second quarter may have also dampened market sentiment towards EM as suggested by the inflection of the upward trend in earnings growth expectations since August. EM economic growth has decelerated since the beginning of the year (from 5.8% year-on-year in Q4 2017 to 5.3% year-on-year in Q2 2018) but remains high relative to developed markets, and surveys on economic activity (PMIs) have lost momentum while staying above the expansion threshold.

Nevertheless, EM corporates’ earnings are high compared to prior cycles’ peaks while equity valuations are close to multi-year lows. EM equities are about 30% cheaper than developed market equities, based on relative long-term price/earnings ratios.

Global factors continue to be headwinds for EM

The short-term outlook for emerging markets is mostly driven by the fluctuations of the US dollar and the pace of developed market monetary policy tightening, while ongoing trade disputes could bring further bursts of volatility. In contrast, respective governments’ policy responses could offset some of the negative effects from these external shocks. For example, the recent actions from central banks in Russia and Turkey helped to stabilise emerging markets and lowered equity volatility.

The US dollar should remain broadly stable, or only gradually appreciate on a trade-weighted basis, as the Federal Reserve normalises its monetary policy. The US dollar index (DXY) has declined by 2.9% since mid-August despite strong economic growth in the US, suggesting this deprecation possibly reflects the widening of the US trade deficit (from US$42bn in May to US$51bn in July). Therefore, the potential knock-on effects of the trade negotiations for the US trade deficit are likely to have a greater influence on the dollar as we move forward into next year.

Trade friction likely to influence the medium-term outlook for EM

The US-China trade dispute is likely to lead to a binary outcome, i.e. a trade deal or a trade war. If the US and China eventually come to an agreement in the coming months, it would likely benefit global equities and have limited direct economic impacts. On the other hand, if the trade dispute escalates we could see negative economic impacts in the medium-term with an increase in inflation from higher tariffs and a drag on the global economy. The IMF has estimated that the drag could amount to 0.5% by 2020 if the tariffs threatened by various trading partners are all implemented. In this pessimistic scenario, where the US cannot negotiate a trade deal with China, we would expect a correction in US equities as market participants realise that it could be a lose-lose situation. The possible rise of US inflation may force the Federal Reserve to increase interest rates more aggressively than anticipated, which will likely be disruptive for markets globally.

Emerging markets are no longer a cyclical play

At an aggregate level, EM accounts for almost 60% of the global GDP[1] in 2018 and this share is expected to grow, according to the IMF. Besides, the composition of the MSCI Emerging Market index has changed over the past decade and the proportion of cyclical sectors has declined since 2008. Financials, consumer goods, and technology now represent a significant share of the benchmark. Technology has been the fastest growing sector in terms of percentage of the index for the last ten years, representing just 10% in 2008 to almost 30% today. In contrast, the energy and materials sectors, which then accounted for almost one third of benchmark, account for 15% today.

Quality stocks to make it through the cyclical bumps

Overall, we believe the sell-off in EM equities may have been overdone but the ongoing geopolitical risks, the possibility of higher rates in developed markets and the recent slowdown in economic activity could continue to be a headwind for EM equities at an aggregate level. Therefore, we believe that long-term investors seeing buying opportunities in EM should use fundamental screening to reduce the risk of falling into a ‘yield trap’.

Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage, superior profitability and lower earnings variability, which suggests they are aptly managed and can quickly adapt to economic changes. This is highlighted in the relative performance between the MSCI Emerging Market Index, and the MSCI EM Select Quality Yield (SQY) Index, which focuses on three criteria: profitability, leverage and earnings’ quality, before selecting the top 50% companies exhibiting the highest dividend yield. Typically, the quality screen provides greater defensive characteristics in periods of bear markets, such as during the commodity crash in 2014 and 2015.

[1] Based on Purchasing Power Parity (PPP) weights which are individual countries' share of total World GDP at purchasing power parities. PPP theory relates changes in the nominal exchange rate between two countries’ currencies to changes in the countries' price levels.