Q&A: Can emerging markets maintain their mojo?

07-25-2017

Since hitting a trough in early 2016, emerging-market stocks have enjoyed a strong run. Can it continue? Portfolio manager Leonardo Vila offers his perspective.

Q: What has been fueling support for emerging-market (EM) equities over the past year or so? The EM move initially coincided with the rally in commodity prices. Overall global growth, particularly in developed markets, was further supportive. Yet EM stocks are trading at only 12 times their expected earnings per share for 2017, compared to U.S. stocks that are trading at a price-earnings ratio (P/E) of nearly 18 times, based on MSCI indexes. In addition, EM earnings growth expectations are accelerating. We expect 15-20% earnings-per-share growth in 2017 versus 12% for developed markets, aided by GDP growth rates that are much higher for EM than developed markets.

We have begun to see some benign disinflationary pressures, led by lower energy and food prices, as well as strength in EM currencies relative to the U.S. dollar. That suggests EM central banks will remain accommodative for longer. It’s likely rates could actually fall further in some markets, such as Brazil, India, Russia and South Africa.

Take all this together, and we think the environment remains favorable for EM equities.

Q: How have emerging countries responded to monetary normalization in the U.S. and similar moves by other central banks? Interestingly, the move toward rate normalization in the U.S. is not affecting foreign currencies as one would expect. When former Federal Reserve Chairman Benjamin Bernanke simply breathed higher rates in late spring 2013, foreign currencies, especially EM currencies, plunged. That was the infamous “taper tantrum.” This time, U.S. rates actually are going up and yet EM currencies are appreciating.

To be sure, after lowering interest rates for some time largely due to accommodative U.S. policy and lower inflation, many EM central banks have halted rate cuts now that the Fed is starting policy normalization. But not all. Brazil and South Africa just cut their rates, and in the absence of meaningful inflation, many EM economies probably could handle additional rate cuts to support their economies. Central banks, after all, don’t exactly have a great track record when it comes to engineering targeted inflation.

Q: Is trade becoming less of a factor for certain EM countries? For years, China’s needs and growth largely dictated the success of other EM economies as they exported natural resources and intermediate goods to China. But as China has slowed from the torrid pace of several years ago, some EM countries have lessened their reliance on China and found new drivers of economic growth, much of it domestically in infrastructure and consumption. Some markets, of course, are and will continue to be intertwined with commodity exports, like Russia and Brazil

Q: Do you expect China will strike a good balance between maintaining structural reforms and sustaining growth? China has thus far surprised many investors by its ability to implement reforms and yet grow, albeit more slowly, at the same time. We agree it is executing better than expected. China made a number of missteps in the past, i.e., excessive stimulus, inappropriate market intervention, wastefulness, but it’s learning as it goes. It wants to redirect its economy from what worked in the past, namely manufacturing, to a new future driven more by services and domestic consumption. This ongoing shift has made the market quite volatile, but the world is giving China credit for progress. Just last month, MSCI decided to partially include China’s A-share market into its EM Index.

Q: Are there countries or industries that you see as particularly attractive? Among countries, we like Brazil. The country is climbing, if not clawing, its way out of a recession. And it continues to suffer from the ongoing political saga. But regardless of who is in charge, there is a political will to do the right thing and get reforms passed to set the country’s future on a better economic and fiscal path. Its Senate recently passed labor reforms that provide some flexibility, and because inflation continues to trend lower, its central bank cut rates 100 basis points in May and has room to make additional rate cuts to stimulate growth. We expect another 100 basis-point cut this month, and more before year-end.

Then there’s Mexico. If you’re positive on the U.S., you have to be positive on the nation’s neighbor and third-largest trading partner—as long as you don’t follow White House tweets! Nafta talks will be underway soon, so we’ll see the actual impact on that trade. But year-to-date, the MSCI Mexico is up 29.5%, while the S&P 500 is up 9.8%. Which side of the wall would you rather be on?

With the prospect for higher U.S. interest rates dimming somewhat, rate-sensitive sectors such as Technology should benefit. You can find great names in typical Asian tech markets, i.e., Korea, Taiwan and China. Keep in mind, Apple’s iPhones—and most electronic devices—are made in EM countries.

Q: What are the risks to your outlook? Clearly, political risks remain in the forefront as we monitor developments in Brazil, Turkey, South Africa and even the U.S. We also are watching developed-market economic growth—it seems to be leveling off or even slowing—as well as recent softening in commodity prices. That could be sign of weakening near-term demand.

All of that said, we believe a retracement within the EM presents an opportunity to get in at more attractive price levels. As always, it’s important to remember that all investments have a tendency to overshoot as well as undershoot.

Thank you, Leo.