To identify what might lie ahead, we first need to look back: 2017 was a year of tailwinds for emerging markets − global synchronised growth was coupled with positive emerging market (EM) credit growth and global negatives were contained.
There were also more stock-market opportunities to exploit in 2017 than in other years. The new world order introduced by President Trump’s election and approach to foreign-policy management generated opportunities for EM equities, arising from events such as the proposed wall between the US and Mexico; tensions with North Korea; climate-change conventions; Russian sanctions; territorial disputes in the South China Sea; and the repeal of US participation in the Trans-Pacific Partnership - all of these moved markets.
Fast forward to 2018 and we believe that EM equities remain the only real investment-grade laggard appealing to all investors. EM equities are able to offer attractive earnings per share growth, free-cash-flow yields and expansion opportunities – attributes that other equity markets have already partly exhausted. Valuations, too, are still attractive, both relative to history and in comparison with their developed-market peers.
The picture is not entirely positive though. The ‘credit crunch’ of 2007/2008 resulted in an unusual economic cycle and market recovery. As this bull market continues to emerge from the scares of 2007-2008, it remains a nail-biting time for some sectors. Risk taking is still low, while developed market volatility has been substantially lower than usual for an extended period, notwithstanding the surge in the VIX witnessed in early February. The concept of absorbing EM equity volatility has therefore been too much of a stretch for some, with some preferring absolute or even leveraged exposure to EM credit and / or EM sovereign debt due to lower perceptions of risk.
The picture for EM equities for the remainder of 2018 is nevertheless an encouraging one. Macro tailwinds continue as both Latin American and Asian economies are well placed to benefit from the present global synchronised upturn. Despite signs of consumer pricing pressures becoming evident in developed markets and fears of policy tightening in some parts of Asia, inflation is, on balance, unlikely to be sufficiently high in most global emerging markets or Asia (excluding Japan) countries to trigger any aggressive hikes. Consequently, in the absence of a really threatening US yield curve, we believe global EM equities should thrive.
There are other positive factors that should be good for EM equities. Domestic consumption growth, the powerhouse of China’s economy, is one. Others include long-term trends in e-commerce; healthcare; travel and tourism; education; urbanisation; and clean-tech (such as China’s ‘Beautiful China’ initiative). There is also a whole range of technological and other disruptive themes underway and on the horizon, for instance artificial intelligence developments; blockchain; electric vehicles; autonomous vehicles; and high-performance computing.
Where there is an opportunity, it is wise to also keep an eye open for threats, such as the spread of a serious disease. This could be more harmful to the economy than a stock-market crash, terrorism or other geopolitical concerns. It may sound hard to believe, but you only have to look at the impact of the 2003 SARS crises on Asian markets. The heightened geopolitical risks emanating from North Korea are firmly on the radar too, along with the increasing militarisation within north and south-east Asia and tensions in the South China Sea. Domestic EM politics are increasingly important as well: the outcome of forthcoming elections in Latin America and India will be key. Other feasible ‘black swan’ events could emerge, such as chaotic liquidity reversals similar to the 1987 crash, which arose primarily from a clumsy change in central-bank policy from that which had originally been signalled.
Summing up, we believe there is good reason to be bullish about EM equities. It is our continued view that unless any black swan events crop up, EM equity may close the underperformance gap between it and the S&P 500 as well as closing the gap with EM credit that appeared following the credit crunch.
This year started and should continue, in our opinion, with EM valuations being supported by strong earnings per share and the potential for a modest price-to-earnings ratio rerating after years of multiple contractions. In other words, we believe that now is a ‘sweet spot’ for EM equities. However, investors should ensure they maintain positions that are commensurate with their risk profile and assume a slightly higher level of volatility in the second half of 2018 than is currently priced into this asset class.
(A version of this article appeared in Citywire’s Emerging Market Investment Guide)