Last year emerging market (EM) equities rose 11.2 per cent, outperforming developed market (DM) equities by over 360 basis points. We believe this marked the beginning of a reversal of a multiyear trend of underperformance of EM as some of the risks that investors feared have abated and fundamentals for a number of countries and sectors in have markedly improved.
In terms of the risks keeping investors nervous, many had been concerned about the potential implications of DM Central Bank actions on EM assets including higher US Treasury yields, which can raise borrowing costs for EM and a stronger US dollar which could negatively impact EM currencies.
However, the US Federal Reserve (Fed) already started its tightening cycle in December 2015 and since that time, EM assets have performed well as the path of the Fed rate hikes has been quite gradual. Additionally, investors appear prepared for an upcoming rate move this year with markets pricing in a 90 per cent probability of a rate hike in December.
There has also been volatility in US Treasury yields as these touched highs of 2.63 per cent in March and lows of 2.04 per cent in early September. Similarly, the US dollar has been volatile, depreciating on a trade weighted basis through early September. However, since the lows of early September we’ve seen both the US 10-year Treasury yield rise and the US dollar appreciate. Despite these moves, over the past few months, EM equities have continued to rise showing their resilience.
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Another risk, frequently cited as a concern, has been China and the country’s slowdown in growth. In our view, China’s growth may be moderately lower going forward, however, we also believe investors should focus upon the quality and mix of the drivers of the country’s growth.
Following the Communist Party Congress which concluded at the end of October, going forward growth will not be a set target and the focus will be more on the quality and sustainability of growth. Though, to put things in context, China’s share of global GDP growth is bigger than that of the US, Japan and the European five's (France, Germany, Italy, Spain and the UK) combined, 30 per cent versus 22 per cent at the end of 2016, according to the IMF World Economic Outlook.
The magnitude of this growth differential is an important point for investors to consider, especially as this trend will likely continue to stay the same in the future, even if China’s growth continues to slow down. Last year China’s equity market was very volatile ending the year barely in positive territory (up 0.9 per cent) and significantly underperforming broad EM (up 11.2 per cent).
Investors wary of China risks and not able to navigate through the noise would have lost out significantly this year. In fact, year-to-date China is the top EM performer (51 per cent as of November 16). Additionally, the fact that EM could perform strongly without China’s participation in the rally in 2016, speaks to the fact that EM countries are trading according to their own individual fundamentals, policy regimes, and unique drivers, as opposed to a block region driven by China sentiment. This means that investors are appreciating the improvements or differences in fundamentals across different countries and sectors, and it also creates a better environment for active managers.
Additionally, within China itself we are seeing a number of attractive opportunities. Managers are finding many attractive companies in sectors such as e-commerce, technology, insurance, healthcare and leisure. In fact, as wages and disposable income continue to grow in the country, the population’s interest and consumption spending in these areas continues to rise.
On the now famous “Singles Day” on November 11, a record US$25 billion was spent on the day by Chinese consumers. This is nearly four times the amount spent on Black Friday or Cyber Monday, the two biggest shopping days in the US. Moreover, the local A share domestic equity market, which next year will be included in the MSCI index, includes some under-owned but very interesting companies. Lately, the market has been opened up more to foreign investors and investors should not overlook these companies with solid fundamentals and growing market shares as they continue to grow their revenues and deliver strong performance.
In terms of our overall outlook, EM countries now have more solid fundamentals than they had in the past, with stronger currencies, lower current account deficits, higher foreign exchange reserves and falling inflation. This, coupled with structural reforms, higher GDP growth than DM, and the potential to enact accommodating monetary policies, bodes positively for EM growth.
Most of all, the one thing which was missing in EM from 2010 to 2015 was corporate earnings growth. Last year, EM earnings growth finally started to pickup and now many EM countries are seeing positive earnings revisions with earnings growing at double digits. These improvements in fundamentals paired with inexpensive valuations have been noticed by investors and this year, for the first time in a while, we are seeing positive net flows into EM equities - $56bn, as of November 1.
Looking forward, we continue to believe rate hikes will be gradual and with tax reform in the US being far from a done deal we see limited upside pressure on the US dollar. Emerging markets continue to be the best performing equity markets year-to-date, and with a positive fundamental growth and earnings outlook, the upward trend could be set to continue.
Ilaria Calabresi is a vice president at JP Morgan Private Bank
