Emerging Markets Continue to Steam Ahead in Third Quarter


October 12, 2016 [3Q16, Emerging Markets, MSCI Emerging Markets]
Charles Wilson, PhD

What’s driving developing country stocks? What’s needed to support their current valuation multiples?

Iguazu Falls, Brazil

Emerging market stocks continued to rally strongly in the third quarter, as attractive valuations, gradually accelerating developing country economic growth, lower real rates, and improving—if still challenged—earnings growth drove portfolio flows into the asset class. The U.S. Federal Reserve also lent a hand by not hiking its key interest rate over the summer, reining in the dollar bulls and lending support to emerging market currencies, as well as to the energy and commodities complex. The most favored markets were those deemed to be the most oversold, such as Brazil and China.

The MSCI Emerging Markets Index delivered a 9% total return in the three months ended September 30, 2016, bringing the year-to-date return to 16%. We generally avoid financially levered companies and big state-owned enterprises, which tend to dominate the index. These stocks include state-affiliated Chinese banks and various national energy and mining firms, as well as large technology companies that dominate their home markets’ benchmarks. They typically perform well during periods of strong, broad market performance, and draw meaningful passive investment flows. Our process, by contrast, is designed to capture most of the upside and less of the downside during the inevitable pullbacks that we intermittently see in emerging markets.

Our inboxes have been consistently bombarded with notes from equity strategists who remain bullish on emerging market equities in both relative and absolute terms, despite the extended rally. Considering that many of these strategists were predicting new lows in emerging market equities less than a year ago, we take this newfound bullishness with a grain of salt. As we argued last year, emerging market valuations were too low and a rebound was in order. But from here, we firmly believe that we need to see additional earnings upgrades to support the current market multiple. Since the January market low through the end of September, earnings revisions have been driven largely by positive revisions in the energy and materials sectors with negative revisions in four of the 11 index sectors. Those sectors (consumer discretionary, financials, telecom services, industrials) make up nearly half of the index weight. What’s the disconnect? Clearly many emerging markets are in a much stronger position this year than they were last year. But, many stocks are approaching all-time highs in terms of price and valuation, despite the fact that global growth and returns are much lower than last decade, driven by a variety of factors, such as slower global economic growth, higher debt levels, weaker global trade growth, and slower demographic tailwinds (in some cases even headwinds). We believe that without additional earnings upgrades to support the new price levels, stocks remain vulnerable to external shocks, such as eurozone uncertainty and the impact of a change in monetary policy from global central banks.

Considering the tightrope global markets are walking currently, we think our focus on companies with long-term growth opportunities in consolidated markets with strong management and the ability to self-fund that growth is more important than ever. We remain confident that the companies we hold can grow through a variety of macroeconomic scenarios and even take share during periods of market stress. We also believe that focusing on these types of companies can help us maintain a defensive posture relative to the market while still growing earnings and free cash flow faster.

In the long term, fundamentals still matter, which is why in a world that is distorted by monetary policy and fast money passive flows, we still expect to benefit today from exposure to companies with consistent earnings. Earnings hope works well early in normal economic recoveries, but as we approach eight years of extraordinary monetary policy with periodic downgrades of economic forecasts, we have to wonder what normal looks like nowadays. Still, we remain as excited as ever about the medium- and long-term prospects within emerging markets but question if the market has moved too far with too little in the form of additional earnings upgrades in a period of such high levels of uncertainty.

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