Emerging markets: a land of opportunities or challenges?

Emerging market equities have lagged their developed market counterparts in recent years, but are we in line for a change?

Emerging market (EM) equities have lagged developed market (DM) stocks over much of the past decade. But some trends look more promising than headlines would suggest. Earnings revisions for EM equities are finally beginning to look up, particularly in the technology and consumer-discretionary sectors. An improved earnings picture could point to long-term opportunities for EM equity investors in four key areas.

As the world’s second-largest economy and largest emerging market, China is a vital cog in the global economic engine. China’s economy has stalled recently, weighed down by weakness in the country’s real estate sector and sluggish consumer spending. But relief could be coming in the form of accommodative monetary policy and long-term structural reforms.

China is also moving ahead with regulatory reforms aimed at attracting more capital and boosting share prices. China’s nine-point guidelines are encouraging firms to return cash to shareholders. A changing macroeconomic backdrop is making it easier for Chinese companies to pay dividends. While this could be a catalyst for dividend yielders, it’s also a good setup for exporters and market-share gainers. Since the market tends to paint China with a broad brush, we believe investors can find select companies which are trading at attractive valuations.

Secondly, as the artificial intelligence (AI) revolution gains steam, Taiwan is at the forefront, producing more than half the world’s semiconductors. It’s also home to 90 per cent of all global manufacturing capacity for advanced chips that power machine learning. As Asia’s equivalent to Silicon Valley, Taiwan offers investors back-door access to AI at relatively attractive valuations.

Some of the biggest players in the global AI supply chain are based in Taiwan, including testing and measurement firms and manufacturers of substrate, which allows advanced chips to be attached to circuit boards. AI spending has shifted from software to hardware, which should benefit AI enablers across the developing world.

Thirdly, the world’s most populous nation – India – is making a concerted effort to become more competitive on the global stage. Recent initiatives out of New Delhi include improving intercity travel, streamlining the country’s notoriously onerous bureaucracy, improving physical infrastructure and developing an increasingly cutting-edge digital infrastructure. In time, we believe infrastructure improvements and increased business efficiency will ripple across the Indian economy, creating new opportunities for investors. In the meantime, robust consumer spending has supported strong GDP growth in India. Currently, India’s GDP per capita is similar to the level at which China’s growth inflected upward.

Lastly, South Korea has long been an EM powerhouse. Policymakers in Seoul are looking to attract even more investment by improving the shareholder experience for South Korea’s listed companies. The government’s ‘corporate value-up’ programme is aimed at boosting stock prices in part by improving corporate financial disclosure, while also encouraging stock buybacks and higher dividends.

These may seem like common sense proposals, but they can be a tough sell in a country dominated by family owned conglomerates (chaebols). Reforms will take time, but we believe investors will eventually see benefits in the form of increased shareholder value – particularly in autos, financials and industrials.

EM equity opportunities are best captured through an active approach that incorporates both fundamental and quantitative research. Skilled investment managers can spot quality businesses in high-flying growth sectors as well as in struggling industries and weak macroeconomic environments. With EM earnings recovering and valuations still attractive, this may be an opportune time for investors to give EM equities a closer look.

While emerging market equity underperformance is advanced, the conditions for multi-year outperformance do not yet exist.

To start with, it is important to understand why EM stocks have ailed in the past 10 plus years. Extremely disappointing corporate profit growth has been the main reason for EMs’ poor equity performance in absolute terms and massive underperformance relative to developed markets.

EM earnings per share (EPS) in US dollar terms have been flat for 13 years, with considerable cyclicality. Investors do not pay high multiples for stagnant profits prone to considerable cyclical fluctuations.

Critically, weak EM profitability and significant equity underperformance have been widespread and are not limited to large caps. Comparing return on equity across the equal-weighted equity indexes reveals that EMs have been chronically below the US and recently dropped below the euro area.

That said, after the stimulus announcement in China in late September, BCA Research upgraded allocation to EMs within a global equity portfolio from underweight to neutral.

The basis was that the adrenaline rush from the recent Chinese policy stimulus might be sufficient to produce a window of outperformance for Chinese equities and, thereby, bolster the overall EM equity benchmark. This was a major change for BCA Research, after underweighting EMs within global equity portfolios for almost 15 years.

Nevertheless, conditions for upgrading the allocation to EM stocks to overweight are not yet present.

First, this adrenaline rush from Chinese policy announcements will not extend to China's real economy. The mainland economy is suffering from debt deflation and balance sheet recession. It is unclear if the announced measures will produce a cyclical recovery in the mainland economy.

Therefore, economies and financial markets, like commodities, leveraged to China’s economy are unlikely to benefit substantially for now.

Second, our composite valuation indicator reveals EM stocks are not cheap. The absolute and relative equity valuations of EM vis-à-vis DM are not low enough to warrant favouring EM stocks merely on a valuation basis.

Certain segments of the EM equity universe, like Chinese banks, have low multiples. Yet, low multiples do not always entail attractive valuation. Chronically low valuation ratios could signify a value trap. This is the case for Chinese banks and many state-owned enterprise (SOE) companies in the EM space.

On the other hand, healthy parts of the EM universe, like the Indian bourse, are expensive. Indian stocks are currently overvalued by two standard deviations relative to their history. For example, the trailing P/E ratio is 63 for consumer staple stocks and 40-45 for mid and small caps.

Third, there has been little corporate restructuring in mainstream EM economies that will structurally boost their return on capital.

Fourth, the global trade/manufacturing cycle has been and will likely remain the primary driver of EM equities, currencies and credit spreads. Latest data confirms the view that global manufacturing and exports are shrinking anew, which heralds a cautious stance on EM risk assets and currencies cyclically.

Finally, EM financial markets’ performance correlates with the US dollar. The broad trade-weighted dollar has sold off sharply in the past two months. This slide has been primarily driven by the narrative that the Fed easing cycle is bearish for the greenback. We believe this thesis is flawed.

Historically, the broad trade-weighted dollar appreciated during some monetary easing cycles and depreciated during others. Hence, empirical evidence does not support the thesis that Fed rate cuts are always negative for the US dollar.

Going forward, the odds are that EMs’ relative equity performance versus DM might fluctuate in a trading range.