Emerging Market Equities: Rising Optimism?

Market Views And Insights

Emerging market equities have staged quite an impressive comeback this year, having recovered significantly since hitting a multi-year low in late January1 . A performance of this calibre is bound to draw attention. Our Head of Global Emerging Market Equities Kathryn Langridge thinks it might be too soon to call it a recovery — a more nuanced view is required. However, she feels there are positive signs that the tide could soon be turning.

In aggregate, corporate earnings in emerging markets (EM) are still disappointing. But we are at a point where negative revisions are bottoming out and we believe it would be fair to say that things are “less bad” than they have been for some time. If you dissect emerging markets earnings forecasts for this year, you would see some enormous swings in expectations – notably in Brazil, where aggregate annual earnings per share forecasts could be up to 40% higher from 2015. As always, it is important to contextualise - the most stressed economies and the most stressed corporates are basing themselves off an extremely low base, from which any recovery could be considerable. But clearly, there is an interesting story in the making.

It goes without saying that the trade-weighted US dollar has a significant impact on emerging markets. If one were to accept that the bulk of US dollar adjustments have happened for now — and this has been the principal driver in the recovery of the emerging markets in the last few months — then without a structural recovery in profitability, this rally would fade. And I would assert that quite strongly.

However, it is equally important to note that profit margins across emerging markets ex-financials are at a very low point (see chart below). We are back to where we were in 1999, post Tequila crisis, post Russian crisis. Expectations are also extremely low. The drivers of margins are critical for emerging markets from this point. They are a function of three things: commodity prices, industrial production growth, and a process that can be described as “self-help”.

Figure 1: EM non-financial net profit margin

Positive signs seen in companies with “self-help”

Given that it is notoriously difficult to predict which way commodity prices would move, it might be prudent to remain agnostic on the issue and assume that prices could stabilise at current levels. With regards to industrial production growth in emerging economies, we are seeing signs of stability and recovery as the risk of recession fades. So, we believe the balance of risk is positive.

This is particularly true for outliers like Brazil and Russia. We are seeing corporate earnings coming through which are no worse than worst expectations in both these countries. And there are some positive surprises in the strongest companies which have benefitted from consolidation in the wreckage of their environment.

As mentioned earlier, the third area where we are beginning to see differentiation is what I call “self-help” — where companies have cut production, reduced production capacity and addressed balance sheet stresses. I would also include those who have reduced underlying leverage and cut wages to keep a lid on costs. These efforts could lead to improvements in productivity, which could ultimately feed through to margins.

And we are beginning to see some positive, if tentative, signs. This comes after five years of compression, deceleration and disillusionment. But we are definitely beginning to see, from the bottom up, signs that the worst is behind us. The distribution may be uneven and therefore, it is difficult to make a big, blanket call. But we are looking to these signs in a much more positive way.

1Financial Times: MSCI Emerging Market Index

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Market Views And Insights