01 Dec 2017
The improved fundamentals of emerging markets warrant a more optimistic approach to investing. Raheel Altaf, manager of the Artemis Global Emerging Markets Fund, explains why.
Emerging market equities are back in favour. By the end of October, they were up 33% on the year (in US dollar terms), outperforming developed markets by 14%*. The strengthening global economy, an improving outlook for earnings growth and particularly good performance from technology companies have fuelled the rally.
Over the past few years, the fundamentals of emerging markets have improved significantly. In aggregate, emerging economies are running current account surpluses. Even the more fragile economies have reduced their deficits. This positive dynamic has boosted profit margins. As a result, analysts’ earnings forecasts have proved to be too conservative and have been revised upwards during the year.
The recovery appears to be restoring the longer-term trend of emerging markets outperforming developed markets – a trend that has been challenged in recent times, as the following chart indicates.
Emerging markets’ relative performance vs. developed markets (MSCI indices in US dollars)
Source: MSCI/Bloomberg in US dollars as at 3 October 2017.
Given commodity and energy prices have lost momentum this year, the performance of emerging market stocks may seem unusual. In the past, periods of weak commodity prices tended to go hand in hand with falls in emerging market stocks. Although odd in a historical context, the divergence this year is not surprising given how the constituents of the market have changed over time. Ten years ago, the top three sectors in the MSCI Emerging Markets Index by weight were financials, energy and resources. But now, as a reflection of global demand for goods made in emerging markets and the strength of their domestic consumers, the top three sectors are technology, financials and consumer discretionary. So in aggregate emerging market equities are much less dependent on commodity prices than they were historically.
In addition, the correlation between the dollar and emerging market equities has fallen in the last year, perhaps as a result of the improvement in emerging economies. A major concern for investors at the start of the year was the impact a stronger dollar might have on emerging markets. Indeed the consensus view was that the dollar would rise over the course of the year. But so far, the exact opposite has occurred. Not only has the dollar failed to rally, but – as an indication of the resilience of emerging market economies – every major emerging market currency has appreciated against it (Chart 2). Emerging market currencies offer attractive yields and the carry trade (where investors borrow low yielding currencies to buy higher yielding ones) is currently working well – a sign that foreign investors are more optimistic about emerging economies.
Year-to-date performance of emerging market currencies (total return against trade-weighted US dollar)
Source: Bloomberg as at 31 August 2017.
Emerging market equities are trading on cheap valuations compared with developed markets. They look particularly attractive against US equities, where there are concerns that valuations are looking stretched. In addition, economic recovery has led to improving profits margins and the growth outlook for emerging markets is now better than for developed markets. Hence they are in the ‘sweet spot’ of cheaper valuations and better growth. Investors have been taking note of this – inflows into the asset class have turned positive this year. Yet investors are still underweight, suggesting that there is further to go.
Political risk remains, of course. Earlier in the year, political scandals re-emerged in Brazil. More recently, South Korean stocks have fallen amid rising regional tensions with North Korea. These events are not uncommon in emerging markets. Political instability and associated volatile moves in asset prices have come to be expected. Investors need to be mindful of country and currency risk but in our experience these events have also offered compelling opportunities to buy into companies with strong fundamentals.
At the moment we see a particular opportunity in value stocks (stocks that trade on valuations lower than the market’s average). Over the past few years, value stocks have underperformed globally, as investors have shifted to the ‘safety’ of stable growth stocks. Amid a synchronised global economic recovery, we still believe that the outlook for value stocks remains promising. As Chart 3 illustrates, the potential for value stocks’ performance to catch up with that of growth stocks is significant in both emerging and developed markets. We are positioned for this, making our fund an outlier among the peer group. The fund trades on a price-to-earnings ratio of 9.6x compared with 12.7x for the market – a 24% discount.
Source: MSCI/Bloomberg. MSCI Value and MSCI Growth indices in USD, total return as at 29 September 2017.
Looking to the longer term, emerging markets are under-represented in world equity markets. Emerging markets make up a third of the world’s GDP in nominal terms (nearly a half at purchasing power parity terms). They also produce around 35% of the world’s exports. Yet they are under-represented in equity markets, being only just over 10% of the global benchmark. Over time, emerging markets’ weighting in the equity market should catch up with their global footprint. This is likely to offer a great opportunity for long-term investors.
Raheel Altaf manages the Artemis Global Emerging Markets Fund alongside Peter Saacke; visit the fund page for further information about the fund, its performance and current positioning. You can also watch Raheel’s latest video to hear more about where he is seeing opportunities in emerging markets.
* Source: MSCI Emerging Markets index vs. MSCI World index
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