Markets & Economy
2017 Mid-Year Outlook: Emerging Markets
Equities and Bonds Appear Attractive as Traditional Vulnerabilities ImproveJune 16, 2017
- The traditional vulnerabilities of emerging markets—in terms of fiscal health, external obligations, private liabilities, and political stability—have improved meaningfully.
- The outlook for company earnings and shareholder returns is improving, but this is not fully reflected in equity valuations.
- We broadly favor local currency sovereign bonds over corporate debt and U.S. dollar-denominated government bonds, although we are hedging some currency exposure.
- We continue to watch developments in China’s transition to an economy that achieves higher-quality (albeit slower) growth. This remains an important multiyear theme.
Several of the longstanding vulnerabilities of emerging markets (EMs) have diminished in recent years, making them increasingly attractive relative to developed markets. Overall, fiscal conditions have improved, balance of payment problems have eased, private sector contingent liabilities have fallen, and political environments have broadly become more stable.
Looking forward, we expect these improvements to continue to support both EM earnings growth and the financial strength of EM sovereign and corporate bond issuers. However, emerging markets still face significant risks, and rigorous analysis of their economies and political environments, as well as close attention to individual company fundamentals, will be essential.
EMERGING MARKETS REMAIN A GROWTH STORY
While the pace of economic growth has slowed from pre-financial crisis levels, the emerging markets are still a growth story. In particular, their margin of growth outperformance relative to the developed economies has recovered after an extended period in which that gap had narrowed. What’s more, around three-quarters of EM economies are expected to see stronger growth this year compared with 2016. As a result, the traditional vulnerabilities of emerging markets should continue to decline.
The specific countries driving EM growth currently include Indonesia and India. Indonesia’s economy has recently expanded at an annual pace of about 5%, although its favorable demographics give the country the potential to grow at a 6%–7% rate. India also has obvious demographic advantages that should continue to power annual economic growth of 7% or more. The economic reforms, including deregulation and tax rationalization, that the Narendra Modi government is pursuing should help sustain that strong growth.
In addition, Russia is emerging from a recession caused by the steep drop in oil prices in 2015, as well as international sanctions related to its conflict with Ukraine. Also, Brazil’s economy is beginning to show initial signs of bottoming after a very severe two-year recession. Policymakers have introduced several key structural reforms that should improve long-term growth prospects by improving governance standards in state-owned enterprises and opening the oil sector to foreign investment. Growth should return slowly over the next few quarters, assuming the political backdrop remains relatively stable.
While the pace of economic growth has slowed from pre-financial crisis levels, the emerging markets are still a growth story.
TURNING POINT FOR COMPANY PROFITS
The tide also may be turning for EM company profits. Recent developments provide evidence to support this view:
- After years of disappointment, 2016 marked the first time since 2010 that earnings per share growth in the emerging world ran ahead of the developed markets.
- We are also seeing an uptick in 2017 earnings expectations. The headwinds to earnings that had been affecting a number of emerging markets appear to be stabilizing.
- Profit margins among EM firms also appear to be widening as a result of better cost management and productivity gains, which are running ahead of wage growth for the first time in a number of years.
We expect to see further improvements in earnings growth, as profit margins in most EM countries are currently below historical averages—although some markets have further to go than others. For example, margins for nonfinancial companies in Brazil and Russia are still well below historical levels.
As earnings growth improves, so should shareholder returns. We have seen evidence of this in the recent uptrend in return on equity in emerging markets relative to the developed world. This trend bodes well for dividend yields and share buybacks.
POSITIVE EARNINGS STORY NOT YET REFLECTED IN VALUATIONS
EM equity valuations do not fully reflect the potential positive turn in profits and shareholder returns. In price-to-book terms, emerging markets now are trading significantly below their historical levels and at a considerable discount to the developed markets. Admittedly, shorter-term price-to-earnings (P/E) multiples have moved higher in some markets, reflecting their recent strong performance. However, given their previously depressed levels, we do not view EM P/E ratios as particularly stretched.
Overall, the improving prospects for EM equities are reflected in burgeoning investor flows into the asset class. While mindful of the risks, we are encouraged by the brighter picture for corporate earnings.
SELECTIVE OPPORTUNITIES IN LOCALLY DENOMINATED EMERGING MARKETS DEBT
There are three distinct segments we consider within the EM debt asset class: sovereign bonds denominated in U.S. dollars; sovereign debt denominated in local currencies; and higher-quality corporate bonds, which are almost all dollar denominated. With inflation moderating and high real interest rates, we currently are finding the most attractive opportunities in local currency sovereign debt—although, in some cases, we are choosing to hedge the currency exposure on these assets. Locally denominated EM debt issued by countries that are easing monetary policy, such as Russia, can offer the opportunity to benefit from interest rate cuts. Select countries that are pursuing significant macroeconomic reforms, such as Egypt, also underpin cautiously attractive investment outlooks and increasing investor demand for local assets. While EM currencies generally appear attractively valued as a result of the U.S. dollar’s broad strength since 2014, we prefer to maintain tactical exposure to select local currencies.
We are also finding selective opportunities in EM corporate bonds, although valuations are elevated after the 2016 rally in the sector. The default rate on high yield EM corporates was approximately 4% in 2016, and we anticipate a default rate of less than 2% in 2017.
RISKS AHEAD FOR CHINA WITH ECONOMIC TRANSITION STILL A MAJOR THEME
In terms of the risks to our outlook, we continue to closely watch internal developments in China, where a sharper-than-expected economic slowdown, disorderly currency depreciation, or tightening of credit conditions all have the potential to reverberate across global economies—Asian economies in particular. We have some concerns about the stability of the Chinese banking sector, given the amount of leverage in the system and the buildup of unrecognized nonperforming loans.
We believe China is likely to keep its fiscal and credit stimulus measures in place in the near term. However, with top leadership positions for the next five years scheduled to be decided at the Communist Party’s National Congress this fall, the Chinese government may opt to make policy adjustments based on political factors that are difficult to predict. Meanwhile, China’s transition to an economy that achieves higher-quality (albeit slower) growth as it moves away from “old economy” industries remains an important multiyear theme.
RISKS AHEAD FOR CHINA WITH ECONOMIC TRANSITION STILL A MAJOR THEME
Idiosyncratic, country-specific factors can create opportunities in EM stocks and bonds, but the same factors can also introduce meaningful risk. For example, the Brazilian markets were quite volatile after the recent news that the country’s president was allegedly recorded encouraging bribery. The political uncertainty has raised concerns that the efforts currently underway to reform Brazil’s pension system will be delayed or dropped.
More broadly, protectionist U.S. trade policies could hurt some emerging markets, including Mexico. However, the Donald Trump administration’s actual trade policy so far has not been as severe as many observers had expected, so our base case is that any protectionist shifts will be relatively modest going forward. We are also monitoring the situation in North Korea, which presents a potential risk for geopolitical tensions to escalate.
The possibility of a renewed downturn in commodities prices presents another risk to the EM outlook. However, many developing countries that depend on commodity exports for growth have made fiscal adjustments leaving their government budgets less exposed to commodity revenue declines than in the past. Also, some major emerging markets, such as India, are net importers of commodities, so they could benefit from a drop in oil prices even as major oil and gas exporters, such as Russia, suffer.
Finally, an aggressive shift in U.S. monetary policy away from the Federal Reserve’s current moderate pace of interest rate increases could create volatility in EM currencies, interest rates, and growth. However, emerging countries generally are in more robust economic shape than in previous years and thus are better positioned to weather rising U.S. rates. In aggregate, current accounts in the EM countries are back in balance, and many EM central banks now have room to reduce rates as inflation falls.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of June 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.
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