Nick Payne looks at the reasons behind the profits recovery in emerging market equities and asks, ‘is it sustainable?
’Despite the recent stock market correction, emerging market portfolio managers remain in good spirits. Having seen their benchmark indices underperform developed market peers for five long years, from 2011 to 2016, it appears the asset class is back in favour. US dollar investors in emerging markets would have registered a price gain of 37% for 20171, sterling investors one of over 20%2. For the month of January 2018 alone, fund flows into the asset class soared by over US$17 billion.
The reasons behind the surge in optimism are well rehearsed – profits across emerging market sectors continue to recover, not just in the more traditional areas of energy and mining, but courtesy of a wave of new technological developments such as artificial intelligence and increased use of facial recognition in mobile devices. In Taiwan, WIN Semiconductors is a key beneficiary of the facial recognition technology used in Apple’s iPhone X.
At the same time, while emerging market economic growth is strong – over 4% for 2017 – valuations remain below those of US and European peers. While the market appears to be questioning the inflation part of the ‘Goldilocks scenario’, the trade-off between decent growth, on the one hand, and low inflation on the other, we are of the view that the bigger risk comes from the US tipping into recession, rather than inflation normalising. Currently, we see very few ‘hot spots’ across emerging markets. Sufficient excess capacity, and slowing growth in China, can accommodate ongoing recovery in Brazil and Russia, in addition to accelerating growth across the ASEAN region.
On the currency front, EM currencies are cruising along, courtesy of a sickly looking US dollar, which, in turn, is helping with the lower costs of servicing dollar-denominated borrowings. The perception of improving politics has helped some currencies. The South African rand has benefited from increased confidence after Cyril Ramaphosa was announced president.
A more competitive dollar, making selling prices increasingly attractive to would-be buyers, coupled with a rise in aggregate demand, have also lit the touchpaper under a wide basket of commodities. A clear beneficiary is Ternium, a leading steel company in Latin America, where demand is set to grow by 10% in its main markets of Argentina and Mexico.
But it’s not just commodity producers enjoying good times. Economically sensitive stocks – from Panama’s Copa airlines to Russia’s Sberbank and India’s HDFC Bank, from Brazilian car leasing company, Localiza, to China’s Dali Foods – are all enjoying a revival in profits. Combined with better capital discipline, and in the case of the banks, an upward sloping yield curve driving margin growth, accelerating profitability is beginning to feed through to improving returns on equity. It is no coincidence that the strength in emerging market equity performance has marched in lockstep with the upturn in the profits cycle.
Yet, despite the prevailing euphoria, risks are not hard to identify.As the new chair of the US Federal Reserve, Jerome Powell, takes up his predecessor’s baton of keeping mild but upward pressure on interest rates, he does so in the belief that this is symptomatic of a normalisation of economic growth. But the US business cycle is already long by historic standards; what would be a worrying sign is if economic activity were to start to roll over, keeping interest rates on hold. Data watchers, be vigilant.
Another potential risk is the rise in the oil price, although there are clear emerging market beneficiaries of a stronger oil price, as well as losers. Russia, the Middle East, Brazil and Colombia, as major oil exporters, are all beneficiaries of a firmer oil price. By contrast, net importers of oil, notably India and Indonesia, will begin to feel the pain if the price rise is anything other than temporary.
No one will deny that emerging markets, as measured by the MSCI Emerging Markets Index, have risen, in US dollar terms, by over 75% since their recent low in January 20163. But stock market engines are typically powered by upwards profits momentum – not sentiment, not politics and not bid rumours, all of which tend to be short-term, ephemeral influences. As long as profit growth continues, we would take advantage of any stock market fluctuations to ‘buy the dips’.
1.Source: Bloomberg as at 31 December 2017.
2 Source: Bloomberg as at 31 December 2017.
3 Source: Bloomberg as at 14 February 2018, in USD, total return terms.