It is now cliché to state that the outlook for 2017 and beyond is uncertain and that the margin for error is high. For starters, high-level Twitter wars with important trade partners and geopolitical allies makes fundamental analysis somewhat difficult (there is a Ph.D. thesis in there somewhere). Investors should also be cognizant that the market’s focus on events in Washington is distracting from the underlying story in emerging markets, which is quite encouraging for two reasons:
- Country fundamentals are improving, particularly with regard to their current account deficits
- And at the company level, returns on equity (ROE) have been stabilizing
What we need now is a return to growth.
Spotting growth signals, by the numbers
With due respect to the potential for trade and geopolitical developments to derail emerging markets’ recent progress, signs of growth are indeed appearing. As companies put together their year-end financials, consensus earnings for aggregate emerging markets earnings in 2016 are around 8%, the best showing since 2011, according to JP Morgan estimates.
For the most part, companies are cautiously optimistic about 2017. A composite measure of Purchasing Manager’s Indexes across emerging markets has been rising since early 2016 and is firmly in expansion territory. This is not only encouraging; it supports the idea that rising ROEs in emerging markets will be an important driver of returns.
Currently, emerging markets enjoy a similar ROE to developed markets (as measured by the MSCI All-Cap World Index benchmark). The emerging market companies have lower debt-to-equity ratios, and their ROEs appear to be slowly rising. With below-average price-to-book ratios relative to the developed world, as well as to their own historic levels, emerging market valuations are worth paying attention to.
Also encouraging: Better longer-term price-to-earnings (P/E) ratios*, as measured by the cyclically adjusted P/E (or Shiller’s P/E)**, which has historically been a good indicator of longer-term equity valuations. With these ratios currently sitting at levels not too far above those of the late-1990s Asian currency crisis, analysts at Citi have calculated that such depressed P/Es indicate a 16% annualized long-term return for emerging markets. This stands in stark contrast to similar calculations done by market pundits for long-term equity returns of developed markets.
Finding traction in times of transition
All of this would be far more encouraging if investors had better clarity on the global economic, trade, and political outlook for 2017. Trying to outguess the new U.S. administration could prove futile for most investors. Meanwhile, the emerging markets space has continued to show encouraging traction, while significantly adjusting to reflect investor uncertainty. Consider the following infographic:
Further down the road, emerging markets will likely be an increasingly important component of the global economy. We believe that more world-class companies with strong long-term growth prospects will emerge from this part of the investment sphere on a regular basis—even if they are difficult to recognize in the current slow-growth environment. This includes the emerging class of Chinese e-commerce businesses.
A widening growth gap
Often, times of transition offer the opportunity to buy such assets at compelling valuations, however early in the recovery cycle. The growth differential of emerging over-developed markets, which has been shrinking since 2012, is poised to widen in coming years, and this would improve the relative attractiveness of emerging market assets. Four factors could drive this widening:
- U.S. growth is likely to pick up, but stagnation looks likely to continue in developed Europe and Japan
- Meanwhile, falling overcapacity, rebounding commodity prices, and improving macroeconomic conditions should drive improved growth in emerging markets
- Declining margins, a key driver of emerging markets’ lower returns, are projected to stabilize in 2017, as excess capacity from previous years is finally worked off
- We will likely see continued volatility in commodity and currency, but higher commodity prices (versus 2014 and 2015) could set a base for strong growth in emerging markets
Due to past false starts, it makes sense to monitor how the differential plays out. However, the growth gap has already begun to stabilize and expand.
The new U.S. administration and its priorities for the next four years will undoubtedly lead to significant speculation, and over the longer-term could affect the fundamental outlook for many emerging markets companies. However, emerging markets have increasingly marched to their own drumbeat over the past two years, and company fundamentals continue to show signs of stability and improvement.
*Price/Earning (P/E) is the price of a share of a stock divided by earnings per share, usually calculated using the latest year’s earnings.
** Shiller’s P/E is based on average inflation-adjusted earnings from the previous 10 years, typically applied to the S&P 500 Index.