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Emerging market equities: under-owned, undervalued and under-rated

10 January 2019

Tim Love, investment director at GAM Investments, discusses the outlook for emerging market (EM) equities in 2019 and analyses where attractive opportunities are likely to lie in a potentially turbulent political and financial landscape.

2018 was a tumultuous year for EM equities, marking the fifth year of declines for the asset class within a decade. And while 2019 could be a volatile year given the crowded political agenda ahead, with EM equities currently under-owned and looking, in our view, very reasonably valued vis-à-vis their developed market equity counterparts, we believe the asset class is likely to prove a popular investment option this year.

In our view, a number of factors provide a more attractive landscape for investing in EM equities in 2019 and support the likelihood of an earnings and multiple uplift.

US-China trade tensions and the slide in the Chinese yuan both hit EM equities hard in 2018. But recent talks between the two countries and an agreement to hold off on additional trade tariffs, originally scheduled for 1 January, are a promising sign. We believe that while trade negotiations could take some time to pan out in 2019, an improvement in the situation is likely as a continuation of the standoff is beneficial to neither the US nor Chinese economy. We hope that any positive developments in trade talks this year will be a strong catalyst for EM equities.

We also believe EM equities are likely to benefit this year from any slowdown in the US Federal Reserve’s (Fed) interest rate hike programme. Rising interest rates have brought sombre tones to EM equities on the back of a stronger US dollar and higher treasury yields. Growth on the whole has been positive for EM countries in 2018, but higher costs of borrowing have hurt those countries that racked up US dollar debt over the years. However, we believe investors could be enticed to reintroduce EM to their portfolios in 2019, particularly as the asset class has come down to relatively cheap levels, should there be a cooling off period in the Fed’s interest rate stance near-term.

Aside from external catalysts, we remain positive on the outlook for EM equities and anticipate further gains for a number of reasons:

  • This asset class is one of the remaining attractive investment grade laggards, meaning value, growth and search-for-yield investors find this universe very attractive and we think there is a significant amount of multiple expansion and earnings generation still to go.
  • We feel the bear market is near conclusion for EM equities and that the current dip could represent a good entry point. In terms of EM valuations, the MSCI EM price /earnings (P/E) has fallen to very low levels, at sub 10x price / earnings compared with 11.85x this time last year. We expect the EM P/E to re-rate upwards to around 14x in 2019.

In terms of strategy exposure, our key overweight countries are currently Brazil and Russia. In Brazil, we believe that the economic backdrop is very supportive for the outlook for equities, in particular the newly elected pro-business government. Market sentiment in Brazil has taken, in our view, a turn in the right direction, with improved customer confidence, interest rate falls, a market-friendly government and cheap valuations. We also like Russia for similar reasons, notwithstanding the possibility of further sanctions being levied. Regarding our recent overweight to frontier markets in the shape of VARP (Vietnam, Argentina, Romania and Pakistan), we remain constructive, especially on Vietnam as the country has been, in our opinion, a strong beneficiary of the US-China trade war and continued outsourcing owing to its pool of very competitively priced skilled labour. We sold down Pakistan last year in the aftermath of the country being included in the EM MSCI index following a strong run of gains. We are currently underweight Taiwan due to changes across the technology supply chain that concern semiconductors and smartphones.

Although we are broadly style agnostic, we are presently leaning towards a cyclical / value bias over growth stocks due to relative valuation attractions and therefore like stocks which are concentrated in financials, materials, energy and utilities. Meanwhile we shy away from telecoms and expensive consumer staples.

The risks to our positive outlook include China’s deleveraging process and a disorderly adjustment to required refinancing and the clampdown on shadow banking institutions. Another major risk on the radar is the recent deadly outbreak of Ebola in the Democratic Republic of Congo which has claimed the lives of over 300 people. Humanitarian efforts to hinder the outbreak have faced headwinds due to instability in the region and complications on the ground engaging local communities with treatment plans. In our opinion, this risk is fundamentally underestimated by market participants and the wider fear is that Ebola could spread out of the Congo and become a global pandemic.

In our view, EM equities look very attractive – they are under-owned, undervalued and under-rated. We consider the relative risk / return profile of EM versus that of developed markets to be favourable on the basis of the former's positive currency-adjusted returns. EM equity valuations are also well below those of the S&P 500 index from a current and historical perspective. Interestingly developed world equity performance (and the recent peaks in volatility) has been materially worse than EM equities in the past quarter. In our opinion, this is primarily because EM equities front loaded their falls in the first half of 2018 and played out actively in a more defensive fashion during the recent S&P 500 index sell-off.

We believe the EM equity space continues to offer an appealing investment opportunity on the back of the evolving EM political, credit and structural landscape. We use consistent, robust, repeatable processes in order to identify opportunities as they arise, with the goal of buying good quality stocks at favourable prices. In our view it is materially more risky to be out of the EM equity asset class than in it at this juncture.

Important legal information
Source: GAM unless otherwise stated. The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
The investment program described herein is speculative and entails substantial risks. The investment program is not suitable for all investors and does not represent a complete investment program. In addition, instruments or currencies can involve greater risks and volatility due to currency rate fluctuations, political, economic or market instability, tax policies, and political, regulatory and other conditions. These risks are greater in emerging market countries. Emerging markets can have less market structure, depth, and regulatory, custodial or operational oversight and greater political, social, and economic instability than developed markets. The value of securities denominated in emerging market currencies are affected by changes in currency rates or exchange control regulations, restrictions or prohibition on the repatriation of currencies, application of tax laws, including withholding taxes, changes in government administration or economic or monetary policy or changed circumstances in dealings between nations.