Five reasons why emerging market equities will be a major investment story over the next decade
Richard Titherington, chief investment officer at JP Morgan Asset Management, explains how the headwinds facing EM and Asia Pacific between 2011 to 2015 are now shifting into tailwinds, supporting a recovery story for the asset class.
1. Reflation is positive for emerging market (EM) assets: Emerging economies and corporate earnings hit a cyclical low in early 2016, and a synchronised recovery in global growth currently offers a supportive backdrop. While we expect Chinese growth to moderate from here, the risks from US protectionism are more contained than initially feared.
2. USD sensitivity: A rising US dollar being a negative for EM equities is a well-worn narrative, but emerging economies are now much better placed to deal with a higher dollar environment. Global sensitivity to the US dollar and the number of EM countries which require foreign capital is lower than it has been in quite some time. The current account deficits of the Fragile Five – South Africa, Turkey, Indonesia, India and Brazil – are no longer as vulnerable, making them more resilient to a stronger dollar. As we enter the last phase of the dollar bull cycle there will almost certainly be some headwinds for emerging markets (which will most likely manifest in some currency pressure), but we believe we are in the final innings and are positioning ourselves accordingly for when the dollar tops out. Currency risk is behind us, not in front of us.
3. The index has evolved: The MSCI EM index has changed dramatically over the past five years. Structural growth sectors now dominate the index, as commodities have become eclipsed by the financials, consumer and IT sectors (IT is now 23 per cent of the index, up from 12 per cent in 2007). The index has experienced a shift away from low return on equity (ROE), higher leverage, excess capacity industries towards higher ROE, lower leverage, new-economy industries. Today’s universe is about domestic growth in sectors such as eCommerce and insurance.
4. Earnings are turning a corner: After four years of earnings contraction, last year, earnings grew by 10 per cent in US dollar terms. Analysts expect 13 per cent growth this year, which is in line with our own bottom-up expectations for the next five years. Earnings upgrades have tended to be concentrated in the materials and IT sectors, so we now need to see upgrades broadening out to other sectors.
5. Rich pickings: ‘Fintech’ is a hot topic at the moment, particularly for those financial companies that were established in the last 15 to 20 years and therefore do not have to manage cumbersome legacy systems. We like a number of Indian financials which are successfully managing to penetrate rural India with lower-cost technology. There are numerous examples of high-quality businesses able to offer compounded earnings growth, higher ROE and lower debt.
Whereas developed market equities over the last 10 years richly rewarded investors with average annualised returns in excess of 7 per cent, the future outlook is much grimmer, with average returns over the next 30 years - in a slow growth environment - expected to drop below 5 per cent, according to JPMAM research. And yet investors remain sceptical of EM equities, even when the cyclical asset class is showing signs of economic strength and global activity is rebounding. As the structural story in EM continues to evolve and opportunities open up, investors may therefore be missing a trick by maintaining an underweight to the asset class.