Two years ago, we argued that 2016 was a year of transition for emerging markets (EMs). After five years of underperformance relative to developed markets (DMs), favourable winds were stirring: we saw early signs that the commodity cycle was bottoming out, productivity among EM companies was improving and the US dollar was likely to peak. These forces would strengthen in the coming two years, after which EMs would become a major investment theme. At the outset of 2018, it is clear that the tailwinds have arrived.
Has the future arrived?
EMs are undergoing a secular transition: from a destination for short- term trading, whose appeal is determined by commodity cycles or currency swings, to a home for long-term investment capital. Indeed, many EM countries are no longer dependent on commodity exports or low-cost manufacturing labour, and are instead developing into economies driven by high-value-added industrial and knowledge- based output.
They have addressed historical current-account deficits, achieving a healthier balance between imports and exports, and debt levels have fallen. Inflation has declined as well, suppressing interest rates. In our view, many EMs look like they are on a path of sustainable, if no longer remarkable, rates of growth. Furthermore, given their demographic, macroeconomic, and increasing political heft, EMs remain vastly underrepresented as a proportion of global stock markets.
Figure 1. EMs’ share of various world totals
Source: MSCI, International Monetary Fund, Thomson Reuters Datastream, EPFR Global and HSBC calculations as at December 2016. Equity benchmark is the MSCI ACWI. EM definition includes 24 markets in the MSCI EM index. Equity funds data are based on a sample of global equity funds
The year 2017 was a good one for EMs. Corporate profit margins recovered, earnings estimates rose and balance sheets strengthened, putting into motion what could be a new capital-investment cycle. Their economies strengthened as current accounts largely climbed into surplus and inflation differentials fell to record lows relative to DMs.
These conditions allowed central banks to ease monetary policy, accelerating GDP growth both in absolute terms and relative to DMs. Given this backdrop, it is not surprising that EM stock markets performed well, outpacing developed markets by 11.85% for the year.
These tailwinds should continue in 2018, and we see six reasons why EMs should perform well:
1. Corporate profit margins should continue to improve
2. EM GDP growth should stay strong relative to DMs
3. EM currencies remain undervalued
4. A fresh capex cycle is due to begin
5. EMs remain under-owned by global equity funds
6. Valuations are supportive
1. Profits: margin gains
Across EMs, net non-financial profit margins have been recovering from a 5.5% trough in 2015 – nearly a two-decade low – to reach 6.7% in 2017. This is still below the 20-year average of 7.7% and far from the Q2 2008 peak of 10.5%.
In contrast, DM margins are near their 20-year peak. Only four EM countries are approaching a similar level: Turkey, Indonesia, Hungary, and South Korea. Margins in the technology sector, featuring outperformers such as Alibaba and Tencent, are near 10%, which is far below the 36% peak.
This is driving an improvement in return on equity (RoE), which bottomed alongside margins in 2015, and we expect further gains this year. On a relative basis, EM margins and RoE are slightly better than those in DM. Crucially, however, EM companies continue to trade at a substantial discount on the basis of price-to-book valuations.
Even though the margins of EM commodity producers have expanded substantially, a further increase (for the average EM company) is likely as the continuing slowdown in wage growth and accelerating industrial production should boost productivity. As a result, a rise to about 7% in 2018 is reasonable.
2. Macroeconomic momentum
Between mid-2010 and Q1 2016, GDP growth in EM economies relative to DMs decelerated sharply, from 7% faster to only 2.5%. According to forecasts, economic growth in EMs bottomed early last year and was followed by upward estimates for 2017 in total and for 2018 (see figure 2). Indeed, EM growth is picking up speed in both absolute and relative terms, and with or without China (see figure 3), and the International Monetary Fund forecasts a continuation of this trend, leading to a 4% differential with DMs over the next three years.
Figure 2. GDP differential v stock-market performance: EMs relative to DMs
Source: Oxford Economics, International Monetary Fund, MSCI, Credit Suisse research as at January 2018
Figure 3. Consensus real GDP growth forecasts for EM countries (GDP weighted, %)
Source: Bloomberg, Credit Suisse as at January 2018
Manufacturing activity in EMs is rising, as headline PMI figures show, but remains far below that of DMs given that the US, Eurozone and Japan are hitting historical highs. Industrial production growth in EMs is marginally stronger than in DMs, but is accelerating as DM levels peak out. Meanwhile, export growth in EMs has risen 10% and is strengthening (though it is well below the height of 40% year-on-year growth), while that of DMs is much closer to its 20-year peak (see figure 4).
Figure 4. Export growth: EMs v DMs (USD, % y-o-y)
Source: MSCI, Credit Suisse research as at September 2017
3. EM currencies: still undervalued
In May 2013, at the height of the taper tantrum, EMs were net borrowers and therefore vulnerable to US monetary-policy tightening. Current accounts in Brazil, India, Indonesia, Turkey and South Africa were negative, and EMs together owed foreign creditors 1.1% of their combined GDP. As the Federal Reserve introduced the possibility of tapering, EM currencies duly took a beating.
The situation is different today. EM companies collectively are a net lender to foreigners (and the public sector) to the tune of 5.6% of emerging-world GDP. Brazil, India and Indonesia are running close to balanced current accounts – particularly when net foreign direct investment is added, achieving a basic balance for each – and the same is true for EMs as a whole.
Figure 5. Current account balances: EMs v DMs (% of GDP)
Source: Oxford Economics, Credit Suisse research as at January 2018
Evidence of this anomaly may be seen in the disconnect between EM exports as a share of the global total (even when China is excluded), which have recovered to the seven-year average of 19.2%, and their real effective exchange rates (see figure 6). These fundamentals will make EM economies more resilient to ongoing US interest-rate normalisation while providing a solid underpinning for sovereign currencies.
Figure 6. EM ex-China: real effective exchange rate v share of global exports
Source: Thomson Reuters, Credit Suisse research as at December 2017
In addition, inflation differentials between EMs and the US are running at 15-year lows and this condition is not being reflected in the valuation of EM currencies (see figure 7). Furthermore, in purchasing-power-parity terms, EM currencies are trading below their long-term averages.
Figure 7. EM v DM: inflation differential against nominal EM currencies v the US dollar
Source: National sources, Credit Suisse research as at December 2017
Clearly, predicting the level of the dollar is a task fraught with difficulty, and the dollar’s recent weakness could easily reverse. Taking all of these observations into account, we do not expect EM currencies to rally strongly in 2018 against the dollar1. Instead, we are convinced that they are well supported and help provide a more stable investment environment.
4. Capex: dawn of a new cycle?
By now it is clear that expectations of a new US capital-spending cycle under President Donald Trump were too optimistic. We also expect that his tax reforms, which make it less costly for US companies to repatriate overseas earnings, will result in firms looking at the real US macro backdrop and modest demographic outlook and plumping for share buybacks, higher dividend pay-outs and the retirement of debt instead of expanding their domestic operations. After all, this is exactly what they have done in the past.
With DM capex near the cyclical low of 110% of depreciation, investors might expect an upswing. However a closer look shows that there is less to the boom in US GDP than meets the eye (see figure 8).
Figure 8. US real GDP growth, excluding mining investment and changes in inventories
Source: CLSA, Bureau of Economic Analysis as at September 2017. Note: Mining investment includes investment in mining exploration structures, shafts and wells, and investment in mining and oilfield machinery
EMs, which are more cyclical and therefore have a greater need for 48 spending on property, plant and equipment, have also been on a capex diet, spending less and less each year as a percentage of sales (see figure 9). Of course, the glaring exception is the enormous Chinese stimulus of 2009. Year-on-year capex growth for EMs troughed at -15% in US dollar terms in Q4 2015, but remains in negative territory, indicating that EM companies have been underinvesting. While this may lead to insufficient future growth in productive capacity, it certainly underpins the argument that there is ample room for an increase in capital spending throughout EMs. And if this happens, it is likely that EMs will outperform DMs, following the precedent set by previous capex cycles.
Figure 9. Capacity utilisation in the BRICs
Source: Markit as at January 2018
But are EM companies generating enough free cash flow to invest? Yes: free cash flow yield is high and climbing and shareholders are already being well compensated by a payout ratio of 36%, which is at the upper end of the historical range (see figure 10). This matters for investors. Historically, both EM and global capex cycles have been linked with EM outperformance of DMs (see figure 11).
Figure 10. Payout ratios, with and without resources: EM v DM
Source: Source: MSCI, Credit Suisse research as at December 2017
Figure 11. Capex cycle: EMs v MSCI EM/World relative performance
Source: Datastream, MSCI and Credit Suisse research as at January 2018
5. EM stocks are not a crowded trade
Investors’ interest in EM equities is strong but remains far from euphoric. The run rate of six-month, rolling net flows into EM mutual funds, at 3.9% of assets under management, is just over one-third of a standard deviation above the two-decade average of 2.01%. In aggregate, global equity funds remained heavily underweight EM equities by an asset-weighted average of 8.3% versus the MSCI ACWI’s 12.7% in late 2017 (see figure 12).
And EM price momentum, while healthy, is far from parabolic. The current bull phase is young and calm: the universe has gained 20% in the two years since January 2016, whereas EM stampedes typically outperform DMs by 79% over 88 weeks (see figure 13).
Figure 12. Global equity funds’ asset-weighted average exposure to EM versus benchmark weight (%)
Source: MSCI, EPFR and Credit Suisse research as at November 2017
Figure 13. EM relative return bull runs: current v previous episodes
|Bull run||Start date||End date||Duration (weeks)||Price return|
|*1||1 Jan 88||3 Aug 90||135||105%|
|2||27 Nov 90||7 Apr 92||71||88%|
|3||10 Sep 92||5 Jan 94||69||64%|
|4||11 Sep 98||18 Feb 00||75||59%|
|5||3 Oct 01||21 May 08||346||207%|
|6||24 Oct 08||4 Oct 10||101||71%|
|Current||21 Jan 16||12 Jan 18||103||20%|
Source: MSCI, Credit Suisse research as at January 2018. Notes: Relative to MSCI World. Inception of MSCI EM on 1 January 1988
6. Valuations: looking good
After a substantial rise from trough valuations, not all EM stock metrics are better than those in DMs, though they remain cheaper than the US. EM stocks are trading in line with their long-term averages of price-to- earnings and price-to-book metrics. The discounts they trade at relative to the MSCI World Index also reflect their long-term averages.
Figure 14. EM absolute and relative valuations: 12-month price-to-book value
Source: Source: MSCI, Credit Suisse research as at January 2018
Figure 15. EMs’ absolute and relative +12-month price-to-earnings valuations
Source: Source: MSCI, IBES, Credit Suisse research as at January 2018
The yield that they offer is now less than their long-term average, however. It is also lower relative to DM equities, which is also unappealing given their historical long-term premium.
In comparison with the US, which is generally considered expensive relative to its own history – on the basis of its cyclically adjusted PE ratio and earnings growth – EMs look attractive. The US market trades at an 38.5% premium to its 30-year average, and has a Shiller PE of 34.5x – a level more extended than at any point in the last 100 years except, ominously, for the 1929 and dotcom bubbles. The market’s ratio of PE to growth (PEG), at 1.9x, is at the top of its 28-year range. The PEG for EMs is also high, though nowhere near that of the US.
No longer trading at trough valuations, the current fair valuations are vulnerable to a spate of bad earnings reports. However, forecast revisions for EMs have not been this strong since 2011 – and, as demonstrated here, there is room for improvement.
Figure 16. EMs breadth in earnings revisions v MSCI EM y-o-y price performance
Source: MSCI, IBES, Credit Suisse research as at January 2018
EMs deserve investors’ favour, not fervour
The resurgence of EM stocks is being driven by strong tailwinds: the macroeconomic environment is supportive, corporate margins are improving and the market is still priced at below 2x. The benchmark holds fewer asset-intensive companies than in the past, and should therefore exhibit and sustain a higher RoE, and currencies are less vulnerable to US monetary-policy tightening.
But EMs risk being victims of their own success. Fearful of missing out, more investors are buying into the story and the resulting momentum could push the market into a melt-up phase. As we’ve seen in the US, a bull market can run for a long time, going from fully to over- to dangerously valued – perhaps even reaching ‘new era’ prices – before collapsing. If they are disciplined and nimble, investors in EMs can enjoy this momentum for some time and leave before the animal spirits turn.
Stepping in to and out of EMs may work for traders lucky enough to time the market well in the short term, but these market participants are missing the long-term opportunity: EMs are no longer a venue for risk-on, risk-off trades, but a universe where quality, value-adding and sustainable companies hold the promise of enduring outperformance. This is what we focus on – and have done so for many years – and will aim to capture, throughout this cycle and the next.
1 This is possible, but sadly beyond our ability to predict