Emerging markets are outperforming in the backdrop of a broadening global recovery, which is boosting demand without yet igniting inflation. Growth in the developing world is expected to widen its lead over developed markets over the next five years.
Free cash flow yields continue to improve. Debt is decreasing and emerging markets dividend yields reached 2.5 per cent in the third quarter in what is still a low yield environment. Investment spending continues to decelerate as companies cancel or shelve projects with pedestrian projected returns.
Capital expenditures have declined the most in Latin America, where sharp declines in capex to sales have coincided with rising free cash flow margins, which are now positive and on par with other emerging markets regions.
Global political discord and geopolitical tensions have generally not daunted emerging markets investors, yet they cannot be dismissed. The key risks we see include the potential for monetary policy missteps, resurgent populism, a war with North Korea, and a deepening of political and economic crises in countries such as Brazil and Russia. Technological disruption is also increasingly reshaping consumer and enterprise behavior, influencing anything from commodity price dynamics to how people shop and invest.
With all this being said, asset prices are rising globally and market volatility is at an all-time low. The emerging markets equity rally also appears to be broadening to the energy and materials sectors, from a recent strong focus on technology and financials.
September’s pause is welcome from our point of view, and could help focus attention on undervalued market segments while easing pressure on some high valuations in the technology sector.
Viewed more strategically, emerging markets companies, with their higher risk premiums, have benefited from yield-seeking in a low-rate world. About 13 times forward earnings, emerging markets equities offer increasing earnings growth, better returns on equity, and slightly higher dividend yields compared to developed markets.
Companies have shelved capex over the past two years and free cash flow margins have risen substantially. Despite these fundamental improvements, emerging markets equities continue to trade at a 25 per cent discount to developed markets on a forward basis. We believe there is still good runway left for the asset class, with long-term performance still lagging its historical peaks and more earnings growth likely to come. The issue of how and why emerging markets internal dynamics could change in the next leg of the rally, however, is at the forefront of our minds entering the fourth quarter of 2017.
A Broadening Rally
The MSCI Emerging Markets Index rose 27.8 per cent for the year through September, outpacing its index counterparts for Europe (MSCI Europe Index up 22.8 per cent), and the United States (S&P 500 Index up 14.2 per cent). Good earnings momentum, rebounding export growth, and strengthening balance sheets helped attract $19 billion in emerging markets equity inflows in the third quarter for total inflows of $65 billion year to date.
The second quarter was notable because the market’s gains were concentrated on a small cross-section of Chinese, Taiwanese, and Korean technology companies. Things appear to be changing. In the third quarter, market interest in energy and materials companies picked up amid more stable oil prices, and better economic data from Russia and Brazil, which are home to large oil, gas, and mining companies.
Earnings growth is strong and rising for the majority of sectors and this supports rising emerging markets equity valuations. This has been a tailwind for stocks with growth attributes and has resulted in a much wider returns gap than we would expect between large cap growth and large cap value.
The tech sector’s trailing price earnings multiple reached 19.7 times in September 2017 from 12.4 times in January 2016, near the market’s bottom. Returns have risen nearly 50 per cent since January, as investors respond to transformational themes including online retail and gaming, and cloud computing. Earnings growth has also been the strongest of any sector outside of energy (where earnings are coming back from lows).
China-based Alibaba and JD.com (e-commerce companies in the tech and consumer discretionary sectors, respectively) and Baidu (an Internet search engine) are among the year’s best-performing stocks. Year-to-date through September month-end, Alibaba is up 97 per cent, JD.com is up 50 per cent, and Baidu is up 51 per cent in dollar terms. Notably, these companies were only added to the MSCI Emerging Markets Index in November 2015.
The tech sector’s relatively asset-light models have translated into stronger earnings and free cash flow. This earnings momentum is one example of the current tailwind to emerging markets growth investors, who can tolerate a higher valuation in exchange for strong earnings growth. Value investing continues to be effective in the large cap space, but significantly less so than growth at this time. In the small cap universe, however, value attributes continue to be rewarded.
Energy and Materials
Valuations have been slower to rise among economically sensitive companies, including those in the energy and materials sectors, which declined 4.8 per cent and 0.4 per cent in the second quarter relative to the index’s 6.3 per cent gain. But they began to pique the market’s interest in the third quarter, rising 13.4 per cent and 10.2 per cent, respectively, and outperforming the index’s 7.9 per cent gain. Disruptive technologies such as fracking and deep-water exploration and drilling have had a deflationary effect on crude oil prices; however, oil demand has been better than expected this year and the Brent crude oil rose by more than 20 per cent in the third quarter.
We believe emerging markets still offer attractive value opportunities, especially if earnings expectations continue to sustainably reset higher. Relative to developed markets, emerging markets equities trade at a 25 per cent discount with comparable or higher return on equity. Although it is too early to tell whether the investment environment (currently favoring growth and momentum stocks) has shifted, we have historically witnessed very strong performance in valuation-sensitive strategies once market leadership changes.