Emerging market (EM) equities continue to be the unloved asset class of choice, an aversion that has been amplified by rising U.S. interest rates, a stronger U.S. dollar and the election of Donald Trump.
Over the last five years through December 2016, the MSCI Emerging Markets Index underperformed the MSCI EAFE Index by 80% on an annualized basis. It has also trailed the S&P 500 Index by a significant margin since mid 2013 (Exhibit 1). The performance gap widened after Trump took office and began to dismantle trade agreements, but has begun to show signs of closing (Exhibit 2). EM stocks currently trade at a 30% discount to developed market (DM) stocks on a forward P/E basis and are under-owned by investors. The greater the level of pessimism, the lower the bar is set for EM companies to exceed depressed expectations.
Exhibit 1: Emerging Market Stock Performance Has Diverged from the U.S...
Exhibit 2: ...But the Gap is Narrowing
Recent struggles have coincided with slowing economic growth and sharply falling currencies across major emerging markets including Brazil, Russia, Turkey and South Africa. EM currencies have fallen below 2009 crisis levels and are significantly undervalued. This has historically led to U.S. dollar (USD)-based debt repayment difficulties and defaults. But most countries have learned this lesson after the 1998 Asian financial crisis and built up a solid buffer of foreign exchange reserves. This allows for the improvement in competitiveness and the terms of trade to bolster exports without risk of a debt crisis. EM economies are highly correlated to commodities, and this area appears to have troughed as well.
Recent EM currency weakness has resulted from acceleration in the USD that is now likely behind us. The yield spread between the 10-year U.S. Treasury and 10-year German Bund is at a 30-year high, suggesting interest rate differentials are at or near their peak and further USD appreciation is less probable. Additionally, the declining GDP growth premium of EM economies versus DM economies over the past few years is likely nearing a nadir. As EM growth improves relative to DM and currencies stabilize, improved corporate profit growth and sentiment should follow on, ultimately leading to capital markets outperformance. In our view, EM equities have endured their crisis and are on the road to recovery.
Most major DM economies - U.S., Eurozone, Japan - are improving, which should benefit EM companies that are highly levered to global growth. China is no longer expanding at a 9% rate, but growth is unlikely to drop below 5% as its central bank is stimulating again. As shown in Exhibit 3, consumption has stabilized in China and emerging Asia and is now trending in the same positive direction as Western economies.
Exhibit 3: Emerging Asia consumption has been stronger than anywhere else
Financials are a good illustration of these cyclical ties to global growth. In our International Value strategies, we own several European banks with significant exposure to emerging markets: Standard Chartered generates most of its business in Asia, Banco Santander is a major lender in Latin America while Itau Unibanco is a Brazilian bank with direct exposure to the recovery of Latin America's largest economy.
Our optimism is tempered by acknowledgement of the risks that linger in emerging markets. The passage of U.S. border tax adjustments, a more hawkish U.S. Federal Reserve, continued negative trade rhetoric, geopolitical risk and the potential for a sharp rollover in China are all concerns we are monitoring. If these risks were to materialize, we believe already depressed EM valuations are less likely to be punished than those in markets with higher valuations and higher expectations.