After Broad Emerging Markets Rally, Get Selective

 

July 28, 2016 [Emerging Markets, Economy, MSCI EM Index]
Ben Kirby, CFA ; Charles Wilson, PhD


We continue to find attractively valued opportunities that we think can deliver compelling cash flow and earnings growth over the next few years in dollar terms, even under a more distressed economic scenario.

Jakarta, Indonesia

With a peak to trough move of nearly 10% on the MSCI Emerging Market (EM) Index at the start of the quarter and ending with a just shy of 1% total return at quarter end, it’s clear we traveled a long way, but didn’t get very far. The markets remain volatile, driven by external events, such as the current direction of the U.S. monetary policy and the evolution of the U.K.’s relations with the European Union following its June 23 “Brexit” vote. Borrowing from the Benjamin Graham analogy framing the market as a “voting machine” in the short term and a “weighing machine” in the long term, there were many votes cast this quarter with less focus on long-term value.

The market appears increasingly convinced that U.S. interest rate policy will remain on hold for the foreseeable future and, in turn, provide ongoing support to global asset prices. The faith in central bankers, or at least faith in their reliance on increasingly easy monetary policy, is at an all-time high, despite its uncertain effectiveness. This uneasy partnership between global markets and central bankers has trained investors to expect support when prices drop but resulted in a perverse relationship in which bad news is treated as good news. Up until recently, good economic news had been treated as bad news by the markets because it meant that the U.S. Federal Reserve may raise interest rates. However, sufficiently weak U.S. economic data in the first quarter and early part of the second quarter, as well as the systemic risk created by the uncertain impact from the Brexit decision, has convinced the market that no amount of good news in the near term will lead to a change in monetary policy. In fact, it’s now widely believed that Europe, Japan, and the U.K. are leaning toward additional monetary accommodation in various forms.

Two things suggest caution despite the market bounce: ongoing central bank support and an apparent stabilization of earnings in emerging markets. Firstly, recent U.S. economic data have improved from first-quarter lows and expectations for a 2016 U.S. interest rate hike have increased from the post-Brexit lows. The potential for higher U.S. interest rates no longer appears to be priced into the market based on recent moves in vulnerable currencies, commodity prices, and fixed income spreads. Any shift in tone from the Fed could be received negatively by what we view as an increasingly complacent market. Secondly, the starting point of the most recent rally was already at a high level in terms of valuation for most major equity indices. The S&P 500 Index is approaching a post-tech bubble high in terms of valuation, despite continuous negative gross domestic product revisions and calendar year 2016 and 2017 earnings-per-share (EPS) expectations that remain largely unchanged but below 2014 highs. Looking at aggregate earnings for the MSCI EM Index, blended forward 12-month EPS is down over 25% in U.S. dollar terms from the peak in 2013. The stabilization in the dollar has helped emerging market earnings. But in aggregate, MSCI EM Index earnings are only about 2.1% higher than the recent bottom in early June. Many of the upgrades for earnings have come in the energy and materials sectors, where earnings forecasts are up over 13% and nearly 40%, respectively, off the January lows. We would argue the positive earnings development in these sectors has more to do with recent dollar weakness than an upside surprise in the underlying fundamentals of supply or demand in each sector.

In periods of uncertainty, it is important to remain balanced and disciplined. With external factors, such as monetary policy and high frequency economic data, continuing to drive equity markets, we maintain our stance of balanced diversification with particular consideration to diversification across style, company size, currencies, and geographies. We also maintain our focus on companies with wide moats, good corporate governance, strong management, and consistent free-cash-flow generation. We believe that in general these companies will grow faster than peers under the broadest range of economic scenarios, an important factor considering the range of economic outcomes remains wide and constantly shifting. We also continue to look for opportunities where external factors are less important to the overall investment thesis. In many cases, these stocks have become expensive as investors invest in the same type of safe havens. Despite this, we continue to find attractively valued opportunities that we think can deliver compelling cash flow and earnings growth over the next few years in dollar terms even under a more distressed economic scenario. In particular, we are finding many opportunities in countries undergoing structural reform initiatives, such as India, Indonesia, Mexico, and possibly Brazil, which is off to a good start, but perhaps it’s too early to call. The productivity gains unlocked through some of these reform initiatives have in some respects allowed these economies to disconnect from the global macro picture. We continue to add to our favorite holdings in these markets when pessimistic sentiment increases.

Even after returns of more than 20% between late January and the end of the second quarter, the current multiples on the MSCI EM Index remain well below developed market peers (10% to 40%, depending on the metric and index for comparison). With the MSCI EM Index valuation at or above long-term average multiples, the valuation discount could be more a comment about the current valuation of developed markets than an observation about the value opportunity in emerging markets. Looking forward, future performance of emerging market equities will require positive earnings revisions outside of commodity sectors. While we believe this is highly likely in certain countries (including the reform stories mentioned above), we are still uncertain about all emerging markets and therefore the outcome for index-level earnings. As a result, we think stock-level analysis will again become important as broad-based emerging market enthusiasm shifts back to fundamental investing.

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