The case for emerging markets to continue outperforming is largely predicated on the view that these markets are relatively early in their growth cycle. The MSCI Emerging Markets Index returned 38% in 2017 and 12% in 2016, making it the best performing major global benchmark by some margin over this period. However, there was severe underperformance between 2010 and 2015, creating the potential for further catch-up in the years ahead. The gap in economic growth favouring emerging markets over developed markets, so instrumental in driving equity returns over the past few decades, continues to accelerate.
Emerging-market profit margins are coming back from the 2016 cyclical trough, supporting a recovery in returns on equity and future earnings growth. Even with the equity recovery in emerging markets, the benchmark is trading at mid-cycle valuations, with the price-to-book ratio at its longterm average of 1.8 times and a 25% discount to developed markets. The emerging-market discount relative to developed markets, and the U.S. specifically, is significantly wider when the cyclically adjusted Shiller P/E ratio is applied over the past 10 years. Our view that we are midway through a multiyear upturn in emerging markets remains intact, but it is also worth considering any developments that could disrupt this thesis. The most significant threats in our view are trade; a correction in developed equity markets; a stronger U.S. dollar; a selloff in the Information Technology sector; and disappointing earnings. We are least concerned, at least in the short term, by the one that has perhaps made the most noise so far this year: trade. The good news is that signs point to Trump moving away from a widely targeted trade war to a narrower and more justified dispute versus China’s business practices. The dispute appears to be shifting from a focus on trade and tariffs towards an emphasis on technology-related investment. This is likely to be a drawn-out battle, but one where the implications are very much long term. One area of concern, given our view that emerging markets are relatively early in the cycle, is how we can expect emergingmarket equities to perform in the event of a downturn in developed markets. The first quarter of 2018 was unusual in that it was one of seven quarters since 1995 during which U.S. equities fell and emerging markets outperformed. Over that period, the U.S. market had 27 down quarters. Similarly, if we look back at periods where the MSCI World Index has been down over the past two decades, emerging markets have generally underperformed. Another significant potential headwind for emerging markets is a stronger U.S. dollar. Historically, the dollar and emerging markets have moved in opposite directions. In 2017, the trade-weighted dollar weakened 11%, and the softening continued into the first quarter of this year. However, this
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trend reversed recently. While a stronger U.S. dollar would represent a headwind for emerging-market equities, our view is that any U.S. dollar strength would be more likely to occur versus developed-market currencies, as was the case in 2016, than against emerging markets. There are three key reasons for this currency view. First, real interest rates in emerging markets are much higher than they are in developed markets. Second, emergingmarket currencies look undervalued on a range of measures following the weakness between 2010 and 2015. Third, economic fundamentals in the vast majority of emerging markets have improved, with Turkey being the only significant one to have a current-account deficit greater than 3% of GDP. One factor that has become very relevant for the performance of emerging markets is the Information Technology sector’s large weighting in the index. Last year’s gains at the index level were driven primarily by stocks in this sector, with five large-cap stocks accounting for more than 40% of the emerging-market benchmark’s gains. The Information Technology sector now accounts for 29% of the index weight, up from 10% 10 years ago. Following last year’s stellar performance, Information Technology has been underperforming so far this year, and our stance on the sector is to be underweight for a number of reasons. First, earnings momentum has started to decline sharply. Second, valuations in the Information Technology sector, while not extreme, have become somewhat extended. We also believe that too many investors are chasing performance in the Information Technology sector and that the sector’s current popularity limits gains going forward. Finally, the internet stocks that have been leading the sector face risks from regulation, government interference and lower returns from new investments. As earnings in the sector moderate, we would expect a much more even distribution in earnings growth by sector to unfold in 2018. Any short-term weakness linked to these concerns could offer opportunities for rebuilding positions to take advantage of the sector’s long-term structural growth. After a period of acceleration, we are seeing a moderation in emerging-market growth surprises, and it is a similar story with earnings expectations, which have begun to moderate after last year’s consistent upgrades. Current expectations are for 14% EPS growth in 2018 and 11% in 2019. We believe these numbers are reasonable given our view that emerging-market profit margins will continue to expand from a low base, although we feel that the low end of a 10% to 15% EPS growth range is more realistic. Earnings growth could be put at risk if we were to see any change in the emerging-market reform agenda spurring productivity improvements such as, for example, backtracking on supplyside reform in China.