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Paradox for emerging market positivity

  • 13Apr 16
  • Devan Kaloo Head of Global Emerging Markets, Equities

Investors may feel a strong sense of déjà vu when contemplating the issues confronting emerging market equities today. Three areas have been a source of recurring anxiety in recent years: China, U.S. monetary policy and the state of corporate earnings.

But there remain reasons to be optimistic about the outlook for emerging markets, if you are willing to delve beneath the surface for signs of encouragement.

China

There is no doubt that China’s economy is slowing. Official gross domestic product (GDP) figures show this, but it is also reflected in softening manufacturing activity and the response from authorities to what has been termed the new normal.

Beijing has acted to loosen monetary policy repeatedly over recent months, relaxed rules on residential house purchases to support the property sector and enacted supply-side reforms in the state-owned enterprise sector. Also, contrary to prior expectations, the Chinese government allowed some depreciation of the Renminbi against the U.S. dollar.

But China is not all doom and gloom. There is an abundance of jobs being created, and the economy is undergoing an important transition from one based on investment to one based on consumption. We believe retail sales are holding up well, and so too is the savings rate, which should help consumers keep spending.

In our view, this type of resilience is overlooked, with critics pointing to the slowdown in manufacturing as a sign that China is in trouble. Yet services now account for a bigger proportion of the economy than manufacturing, and the Chinese consumer is a real boon for the economy.

There are, of course, imbalances in the Chinese economy, but the authorities are not blind to them. They are sensitive to the consequences of an economic slowdown and we believe are looking to support the economy through a challenging transition. This is important because stability in China an important sentiment across emerging markets.

Monetary Policy

Expectations for monetary normalization in the U.S. triggered a multi-year dollar rally that created havoc for most emerging market currencies as well as domestic interest rate policy. Currencies devalued, creating a spike in imported inflation. This had to be countered by significant upward adjustment of local interest rates.

We believe the impact on emerging market economies and stock market returns was a significant but necessary evil. Emerging market current account deficits had widened to unsustainable levels and needed to balance. Local currencies were arguably overvalued in the context of persistent inflation.

Where we stand today is after a period of necessary structural adjustment and we believe trade balances have turned and continue to adjust for the better. Looking at the current account balances now, most have moved back into positive territory. Inflation is easing and interest rates are being relaxed across much of emerging markets. The U.S. dollar rally seems to have taken a pause, which is supportive of currencies too.

But the reality is that the economies of North America and Europe, the two major export destinations for emerging market trade continue to struggle. Economic indicators suggest the U.S. economy could actually be slowing down again. While this presents a significant obstacle to an export-led recovery of our emerging economies, one very positive takeaway is that developed market monetary policy is expected to remain extremely loose for some time to come.

In our view, this could be supportive of local currencies as well as give central banks more flexibility to lower interest rates to stimulate domestic demand. Assuming we see no significant near-term resurgence of growth in the U.S. or Europe, the backdrop should remain reasonably benign for risk assets such as emerging market equities, where economic fundamentals look reasonable to us after the adjustment of recent years.

Chart 1: Current Account Balance

Source: Emerging Advisors Group, January 2016
For illustrative purposes only

Earnings

Disappointing earnings are regularly cited as being the root cause of weak equities performance. Forecasts for earnings and revenue growth have faced downward revisions for 2016 across Europe, the U.S. and emerging markets. There’s also an increasing pessimism among investors. But it’s important to distinguish what’s happening in emerging markets from the rest of the world.

Emerging markets earnings growth was around -3% in 2015 in U.S. dollar terms, but that figure doesn’t accurately represent the entire emerging market spectrum. If you strip out resource companies and look at earnings in local currency terms rather than in U.S. dollars, the 2015 figure is actually likely to come in at over 10%.

And the trend is one of improvement. Revenue growth is forecast at over 6% this coming year. Factor in some operating leverage on expected cost control across our universe, and earnings growth could possibly break the 10% mark in 2016 as well.*  

Chart 2: EM Revenue Growth

Source: UBS, January 2016
For illustrative purposes only

Chart 3: EM Earnings Growth

Source: UBS, January 2016
For illustrative purposes only

It would be naïve to downplay the severity of the headwinds facing emerging markets. Yet, it’s equally detrimental to get caught up in the negativity and miss the broader, more balanced, picture. Yes, there are various problems in China, but the country has various strengths in its favor too, such as a very high savings rate and low levels of household debt.

It would be naïve to downplay the severity of the headwinds facing emerging markets.

Monetary policy may have weighed down on emerging market currencies, but this has encouraged much-needed adjustments in the trade accounts of many emerging countries. And finally, earnings are far more encouraging than they seem at first glance.  

As veteran emerging market investors, we’ve been here many times before and take comfort in doing our extensive country and company first-hand research. But perhaps most importantly of all, we’ve learnt not to lose sight of the need for having a long-term view.

*Forecasts are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Ref: 23211-050416-1