10 August 2015

Emerging markets are back in the doldrums. Valuations are depressed, and it is hard to think of a more hated asset class today (bar commodities). Is it time to be tempted?

A sharp economic slowdown in China and the collapse in commodity prices have hit emerging markets (EM) hard. EM equities underperformed the developing world by 8.7% in July – and have underperformed by some 50% over the past three years on a total-return basis, according to MSCI data.

Value investors are starting to sniff at the opportunity. EM equities are trading at just 1.4 times book value, according to Morgan Stanley. This is close to the levels of around 1.2 to 1.3 that have marked a trough in major periods of EM underperformance, we observe. It is close, but no cigar. EM equities lack a catalyst.

Profit recession

Corporate profit and currency trends are working against the asset class. Earnings per share (EPS) have dropped 25% from their mid-2011 peak in what is the longest earnings recession in EM history, MSCI data show. The previous three earnings recessions were associated with EM financial crises (1997-99) or global recessions (2001-02 and 2008-09).

The slowdown is broad based, both by geography and by industry. Each of the 15 largest countries in the MSCI EM Free Index has seen EPS declines since 2011, MSCI data show. The materials (down 86%), industrials (59%) and energy (56%) sectors have led the bloodbath, with medium- and small-cap companies hit hardest, according to MSCI data. The culprit? Tepid domestic growth, profit margin squeezes (reflecting falling commodity prices and a productivity growth slump) and a stronger US dollar due to the looming end of US zero interest rates.

Catalysts for change

What could change this dreary outlook?

  • The US dollar's advance versus EM currencies levels off. I see this as unlikely until the Fed’s first interest rate rise is out of the way (we expect the central bank to pull the trigger by year end).
  • Improving profits: Unlikely, we think, in the short term due to the strong dollar and weak commodity prices.
  • Giveaway valuations: We are getting there, as noted above.

There is also a good argument that emerging markets are increasingly becoming diverging markets. As a result, economic growth and asset price performance could start to vary greatly across economies. Averages can mask a lot of dispersion – and offer a lot of opportunity to outperform. Example: Broad EM equity indices are increasingly a direct play on China. China makes up 24% of the MSCI EM index today, versus just over five percent 15 years ago, MSCI data show.

Conclusion: The EM asset class as a whole may not yet have found its floor. Yet there are opportunities within (we like economies with structural reform momentum). Picking exposures and risks selectively will be crucial for future returns.

CARS ref: RSM-1679

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 06 August 2015 and may change as subsequent conditions vary.

EM equities underperformed the developing world by 8.7% in July – and have underperformed by some 50% over the past three years on a total-return basis, according to MSCI data.