Schroders: EM-Equities with lower growth in 2015
Global emerging markets look supported by strong domestic demand growth and reform potential. However, challenges remain, primarily revolving around a strong US dollar.
As 2014 has progressed, what has become increasingly apparent is the sub-trend and divergent nature of the recovery in global growth. The only developed economy really showing momentum is the US while growth in the eurozone and Japan is stalling and unorthodox policy measures are being increasingly employed. Consequently, rather than assessing how global emerging markets (GEMs) will fare in a global expansionary cycle, we find ourselves instead focusing on how GEMs might perform in a low growth world.
Lower growth for longer GEMs would be expected to be among the primary beneficiaries of a global cyclical upturn given their higher beta nature. However, while GEMs’ exports, in particular manufacturing and industrials have been increasing, the overall effect has so far been more muted than would otherwise be expected at this stage in the cycle.
Meanwhile, import demand for commodities has been weak. A slowdown in the commodity cycle is partly to blame, not least with the US progressing towards energy self-sufficiency, together with the longer-term diminished effects of global trade liberalisation and a slowdown in off-shoring. Weak demand from the US has so far not been reinforced by demand in the eurozone, Japan and China, where growth has slowed and the overall backdrop for GEMs to perform in has become more challenging.
Subdued export growth has weighed on earnings and Institutional Brokers' Estimate System (IBES) consensus earnings growth expectations of around 10% over the next 12 months look susceptible to potential disappointments. We believe instead that investors should look to GEMs’ primary growth driver of domestic demand, together with the potential positive ramifications of reform implementation, for a positive economic and earnings growth catalyst in 2015.
Opportunities – strong domestic demand
There has been much negative market sentiment surrounding disappointing emerging markets export growth. However, we believe investors should not lose sight of the significant underlying domestic demand-led growth in the emerging world. Do not forget the combined population of China and India is over 2.5 billion, let alone the remaining emerging countries, and an expanding middle class is driving strong consumption demand and accounting for an increasing share of wealth creation globally. This structural story remains in its infancy and we believe will continue to create strong investment opportunities.
Opportunities - the new reformers
An important positive for GEMs could come from the increasing number of countries that are embarking on reform programmes to boost or sustain growth. In many cases this follows the election of pro-reformist leaders; for example Narendra Modi in India, Peña Nieto in Mexico, Joko Widodo in Indonesia and Xi Jinping in China. Common reform requirements include the need to rein in the influence of the state on the economy and release the potential of the private sector. However, the necessary reforms are typically country-specific; for example, China is looking to transition its economy away from credit and investment and increasingly towards domestic consumption growth, while in the case of India, there is a greater need for investment and infrastructure spend to reduce supply bottlenecks. While the reform process is unlikely to be smooth in either case, over time, the reforms could lift GDP meaningfully.
Shifting market sentiment
Emerging market equity mutual fund flows have been very volatile over 2014 and it is possible this volatility could continue into 2015 given the still-uncertain global backdrop. The year started with an extraordinary level of investor bearishness towards GEMs, as reflected by net outflows of over $40 billion from dedicated funds. Since then flows have reversed somewhat but year-to-date there have still been outflows of around $10 billion, according to fund flow data firm EPFR Global.
However, significantly, there is a strong case to be made that concerns have already been more than priced in by the market. GEM valuations are attractive with the MSCI Emerging Markets index trading at price-to-earnings (P/E) ratio of around 10.5 times, which is an approximate 10% discount to history and over a 50% discount to the S&P 500 referencing the Shiller P/E ratio – this is the largest discount for over 10 years.
Source: Schroders, FactSet, IBES, MSCI, data shown to 16 October 2014
The challenge of a stronger US dollar
In 2015 we believe the primary challenge facing GEMs is the potential ramifications of future monetary policy normalisation in the US. For example, the prospect of restrictive policy on the US dollar bears monitoring closely given a stronger US dollar has historically been correlated with weak GEMs relative returns versus developed markets. That said, the US dollar has already strengthened sharply on a real effective exchange rate basis over 2014 and we believe it is unlikely that the dollar will continue to appreciate at such a pace in 2015.
It also looks too early to start worrying about interest rate hikes at this stage of the cycle, not least since equities tend to perform well during the initial rounds of rate increases as the positive impact of strong economic growth outweighs the tighter financing environment. Furthermore, although the US is one of the best performing developed economies, its recovery has been sub-trend which may lead interest rates, when they are finally increased, to peak at much lower levels than during a more ‘normal’ cycle. In combination with expansionary policy in the eurozone and Japan, global liquidity is likely to remain supportive for some time to come.
Clearly some emerging economies are more vulnerable than others to higher US interest rates. However, the adjustment process has been underway for many of the perceived weaker economies who in some cases now have narrower current accounts, more competitive currencies and have slowed loan growth. Subsequently, when policy is eventually tightened in the US, we would expect the impact to be more muted than the summer of 2013, not least since the prospect of interest rate hikes is now well known and, at least to some extent, looks to already be priced into the market.
Tail risks remain, most notably in Ukraine and the Middle East, although given the global nature of the current crises, any significant deterioration in either situation is likely to have global rather than emerging markets-specific ramifications. While the recent pressure on energy prices is creating strains on the budgets of certain energy-producing emerging countries, lower prices are a benefit to the energy importers and overall should boost global consumption demand to the potential benefit of GEM exporters.
Cautious optimism for 2015
Our 2015 outlook for GEMs is constructive but more muted than would otherwise likely be the case in a more ‘normal’ global expansionary phase of the cycle. We are currently positioned with a portfolio beta of around 1 (i.e. our overall market sensitivity is broadly in line with the index) and we are fully invested, although have a net underweight exposure to the more cyclical sectors (materials and energy combined). Generally speaking, we have overweight positions in markets which could benefit from potential reformist policy and markets which are beneficiaries of a pick-up in manufacturing and industrial exports and weak energy prices.
We are mindful that the ramifications of a stronger US dollar, a potential tighter financing environment and weak commodity prices could have a negative impact on emerging markets equities. Nevertheless, over 2015 we believe GEMs should deliver reasonable absolute and relative returns compared to developed markets, supported by attractive valuations, strong domestic demand and improving exports.