Emerging markets have posted strong performance since their trough early last year: look no further for evidence than the 30 per cent rally in EM equities in 2017. As we head into 2018 EMs face heightened geopolitical and currency risk as well as pockets of overvaluation. We believe there are still great opportunities in the months ahead. But finding them requires searching across asset classes.
EM equities returns this year have been driven largely by fundamentals. Against a backdrop of solid global trade growth, EM earnings estimates have been revised upward throughout the year. And since only a tenth of EM equity returns to date were generated by an expansion of earnings multiples, we think there’s more room for increases ahead.
Even though valuations of EM equities have risen somewhat, they still trade at a large discount to developed markets. Many developing countries’ fundamentals are also improving. GDP growth across emerging markets is expected to increase to 4.6 per cent in 2018, while inflation is declining or stable in most major markets. This combination puts them in a “sweet spot” allowing room for potential stimulative policies if required.
External account balances have adjusted significantly. This makes EM countries less reliant on foreign capital and less vulnerable to rising interest rates in developed markets. And reforms and better governance in various counties are further brightening the growth prospects across the developing world.
As these improvements help support positive sentiment for investors in EM, we think the following opportunities are worth watching in 2018:
The EM Tech Enablers
The rally in EM equities to date has followed a very similar pattern to the US market. About a third of the gain is accounted for by big digital leaders in fields including mobile and e-commerce. Investors have come to view the US leaders – Facebook, Amazon, Netflix and Google, collectively dubbed the FANGs – as having unassailable positions. EM markets have their “FANGs” equivalent: Alibaba, Tencent, Samsung, Naspers and Taiwan Semiconductor, which between them have achieved about three times the return of the rest of the EM equity universe during 2017.
The EM rally could broaden as investors warm to a wider range of companies and sectors that support the growth of these digital leaders, including DRAM producers and electronic component manufacturers in Taiwan and South Korea. These are benefiting from industrial consolidation and better capital discipline, which in turn is supporting rapid growth in cash profits and dividends not yet reflected in earnings multiples.
Large Cap Chinese Banks
The major Chinese banks trade at half the valuation of their global counterparts despite delivering superior profitability and twice the dividend yield. Moreover, the business environment for these lenders is improving: profitability across Chinese companies has strengthened this year – see for example the 35 per cent increase among many industrials – which feeds through to lower credit risk for the banks and reinforces the quality of their loan portfolios. At the same time, the Chinese authorities have successfully clamped down on “shadow banking” activities among the country’s smaller institutions. This suggests that the efficiency of the financial system is improving – more resources are being channelled into productive activities rather than financial engineering. Taken together, these developments reduce risk and drive up profitability for select Chinese banks.
Brazilian Government Bonds
Inflation in Brazil has collapsed from more than 10 per cent in January to about 2.5 per cent in November, opening the way for steady reductions in interest rates which have boosted bond returns. With 10-year nominal yields in Brazil still at 10 per cent, real yields in Brazil are among the highest in the world, pointing toward continued strong returns for bond investors in the coming year. Much of Brazil’s incipient economic recovery has already been priced into the stock market, which climbed 69 per cent in 2016 and is up another 30 per cent this year, putting it on a punchy earnings multiple of 24x. We see better risk-adjusted returns at this point in fixed income than in the broad Brazilian equity market, though there are select company opportunities in both equity and credit.
We believe that by looking cross-asset classes plenty of interesting opportunities can be found in different sectors and countries.
Targeting the most attractive opportunities across equity and bond markets can help create a more balanced portfolio—and smooth the ride of a prolonged EM recovery into 2018.
Morgan Harting is portfolio manager for AB Emerging Market Multi Asset at AllianceBernstein