Markets & Economy
2017 Outlook: Emerging Markets EquitiesJanuary 17, 2017
- Economic growth relative to developed markets is now stabilizing. China is the one exception, but a growth slowdown should not be confused with a growth crisis.
- This improved economic growth should provide a healthier environment for corporate earnings, particularly if margins begin to improve, as we expect.
- The potential for higher U.S. interest rates is resurrecting some of the concerns for emerging markets. However, most countries are in much better shape to weather what should be modest increases in interest rates orchestrated by the Fed.
- The prospects for growth remain strong, although in the near term investors may see short-term market volatility as top-down concerns, including uncertainty about economic policies in the U.S. under a Trump administration, circulate. Importantly, given robust fundamentals and areas of superior growth, we believe there are still many rewards to be found.
The outlook for emerging markets equities remains bright. Improving economic growth and a revival in corporate earnings should bode well for the year ahead. Economic growth relative to developed markets has now stabilized. In fact, the growth premium is once again expanding (Figure 1) as the larger economies of Brazil and Russia, which have been suffering tough recessions, now show signs of a turnaround. Meanwhile, Asian economies generally remain robust, with India, in particular, powering ahead. India is a great example of a country that is making the hard reforms now in order to maintain its future prospects. The country’s prime minister, Narendra Modi, has shown willingness to push through reforms that may cause short-term pain so that the economy can be positioned for long-term gains.
China’s economy, however, continues to slow. But a growth slowdown should not be confused with a growth crisis, in our view. China ultimately has the ability and willingness to apply policy actions that should prevent its economic and debt dynamics from becoming disorderly. It is also important to remember that China is going through a major transition from an economy led by manufacturing and investment to one more based on services and consumer demand. This is a multiyear transformation and should be monitored as such. Beyond China, economic growth for emerging markets as a whole appears to be accelerating.
Emerging markets gross domestic product (GDP) growth relative to developed markets.
As of December 31, 2016
Sources: International Monetary Fund, World Economic Outlook.
POSITIVE MACRO BACKDROP FEEDING THROUGH TO CORPORATE EARNINGS
Improving economic growth is providing a healthier environment for corporate earnings. 2016 marked a turnaround in earnings for emerging markets after a number of years in the doldrums. Some of this improvement was helped by the revival in commodities, but we have also increasingly seen more examples of self-help within companies, with a growing number of companies focusing more intensely on cost control, efficient capital expenditure, and improving shareholder returns.
Profit margins in most emerging countries remain below historical averages, but better growth and more disciplined cost management can help improve them. We are already seeing tentative signs of margin expansion among nonfinancial companies. Importantly, for the first time in five years, productivity is increasing at a faster pace than real wages in some key markets. This can only help lift margins, although some countries have more scope for improvement than others.
Despite strong equity performance in 2016, valuations are still attractive as they remain at a discount relative to developed markets, particularly on a price-to-book basis. Valuations on a price-to-earnings basis are a bit more varied, with some sectors—such as consumer staples and health care—slightly above their long-term averages. Earnings growth, however, has been somewhat anemic and may be poised to accelerate in 2017, making us more sanguine about current valuation levels.
WHAT TO LOOK OUT FOR
One possible headwind facing investors in 2017 is the impact of President-elect Donald Trump’s policies. The election of Trump caused some volatility immediately following his victory. If he follows through on his free trade position, trade could be compromised for a number of emerging countries.
It is early in terms of being able to assess the full impact. Most likely, the administration will pursue a pro-growth agenda that includes lower taxes, reduced regulation, and infrastructure spending. If so, these measures could pull global economic growth higher, and this historically has helped emerging markets. The question is whether or not developing markets will be allowed to participate in this based on Trump's preelection trade and tariff policies.
While still uncertain, our current view is that Trump will be more pragmatic in the priorities and policies he pursues. We expect him to ultimately embrace a more practical, business-friendly stance, particularly related to trade.
Meanwhile, expectations for stronger growth are pushing U.S. inflation expectations higher, and the yield curve has steepened. Indeed, after many years, we may finally be on the cusp of change in the trajectory of U.S. interest rates. Higher interest rates are resurrecting some of the concerns for emerging markets about lower capital flows (FDI) and weaker currencies.
However, most emerging market countries are in much better shape to weather what should be modest increases in rates orchestrated by the Fed. Current account positions have improved, foreign exchange reserves have increased, real interest rates are higher, and many emerging market currencies have fallen over the past several years. Therefore, we are more upbeat and would only be concerned if we saw a dramatic and accelerated rise in U.S. rates. Indeed, real interest rates are still relatively high in a number of emerging countries. As local inflation rates ease, there should be scope for central banks to cut interest rates in response.
NEAR-TERM CONCERNS BUT LONG-TERM POSITIVES
Strong performance within emerging markets in 2016 was driven in part by expectations for stronger relative economic growth and a more benign global interest rate environment, with interest rates staying lower for longer. Both assumptions are now being challenged in the wake of the U.S. elections, but we expect emerging equity markets to weather any potential challenges based on the improved fundamentals and growth potential they offer. Earnings trends remain positive, and across the emerging market landscape, there remain very interesting pockets of growth that are hard to find in developed markets. We believe companies that are exposed to that growth, and that have strong management teams, should provide attractive returns for long-term investors.
The fundamental case for emerging markets remains in place. As confidence in the growth potential of these economies and companies increases, so, too, should capital flows into the asset class.
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The views contained herein are as of January 2017 and may have changed since that time.
Past performance cannot guarantee future results.
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