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In the past two decades emerging markets have experienced bust, boom and lately a more stable phase. Not surprisingly, investors now wonder whether it is still worth investing in the region.
High expectations in terms of returns have not been met in recent years by emerging markets, while volatility has remained elevated. This poor relative performance has led to significant outflows, causing emerging equities to become unloved, under-owned and cheap. Have we reached the end of this period of poor performance, or is there a good argument to part with emerging equities altogether?
What will happen in emerging countries in terms of productivity during the next five years? On the positive side, we think there will be a number of factors to support growth in the emerging economies. We expect the commodity markets to enter a new phase following the rout in commodity prices of the past two years. Global aggregate demand is expected to increase in our base scenario and the pickup from current subdued global trade levels should benefit emerging markets. Domestic consumption in emerging markets will contribute. Emerging market currencies are significantly undervalued and we expect this to feed into stronger earnings.
But there are also a number of serious headwinds. China and South Korea are maturing and are entering a phase of diminishing returns following earlier economic reform activities and capital accumulation. Commodity exports are expected to remain a dominant driver behind economic activity in emerging markets and a decline in the commodity intensity of global growth will also cap the upside for emerging market productivity gains. And emerging economies are lagging behind developed markets when it comes to rule of law, regulatory efficiency, fiscal freedom and market transparency.
In summary, although we do expect a stabilization in (cyclical) productivity growth, it is unlikely that growth will return to pre-financial crisis levels. This implies less upside for earnings from a productivity perspective.
As productivity is unlikely to rebound to previous levels, what can we expect for earnings from a cyclical perspective? Although we are somewhat more positive here, one hurdle is the oil price. The US is now a shale oil producer and marginal supplier, and China is making a shift towards becoming a more service-oriented economy. This means we don’t expect the windfall for emerging market commodity exports which we have seen in the past.
Having said that, margins are not particularly high in emerging markets. The profit cycle has room to improve significantly as emerging markets start to benefit from the improved competitiveness resulting from the strong depreciation of most of their currencies. All in all, we expect earnings per share growth in emerging markets to edge up to 4.5%.
“A cautious stance is warranted for emerging markets”
One of the main reasons for optimism in the case for investing in emerging markets today is that they are cheap. On the face of it, the MSCI Emerging Markets Index shows a discount of 25% on a standard price to earnings (P/E) basis compared to the global benchmark. This observation is a powerful plus point for emerging markets, as low valuations bode well for outperformance relative to developed markets in the next five years.
However, despite this optimism on valuations, we must examine whether the current deep discount in emerging markets is largely due to excessive investor pessimism or whether stocks are cheap for a reason with the discount merely reflecting underlying macro risks?
Recently observed macro risks such as the rout in the commodity markets, strong US dollar appreciation and slowing Chinese growth could all be viable explanations for this significant discount. Our research shows that the market has in particular priced in a ‘China factor’ as a systematic risk and this has, in part, shaped the emerging valuation discount since 2011, when the landing phase in China became apparent.
The return component that has become increasingly attractive during the landing phase is the dividend yield. This is 3.0% for the MSCI EM Index, 20 basis points above the current dividend yield of the MSCI AC World Index. This dividend yield differential corresponds with the average seen over the past 20 years. The dividend yield depends on earnings (which we do expect to pick up from current levels), payout ratios and stock prices. Payout ratios are not fixed and are largely a function of corporate capital expenditure. We think overall capex in emerging markets is lower when commodity markets enter an exploitation phase. This raises the payout ratio in conjunction with a somewhat higher expected earnings yield. Adding both these forces together, we expect slightly higher dividend yields of around 3.25% in the next five years.
Are emerging markets the ‘grain which will grow’ in the next five years? Our analyses suggest that a cautious stance is warranted. We do not expect multiple expansion over the next five years and expect the discount of emerging markets relative to developed markets to increase further as uncertainty about China sets in. We do expect an improvement in corporate profitability compared to developed markets, but with the emphasis on earnings growth, returns will probably be highly volatile. However, we also observe that the return prospects for developed market investors are brighter as emerging market currencies are expected to appreciate against developed market currencies. Overall, we prefer a cautious overweight for emerging market stocks relative to their developed market counterparts.