Emerging Markets Outlook

There Is Still Room to Run

 

Key Takeaways

Emerging markets stocks delivered impressive returns in 2017, but valuations for many companies domiciled in developing nations still appear relatively attractive and profit growth is surging, suggesting there is room to run.

 

Stronger local currencies in some nations, an expanding global economy and rising middle class prosperity also bode well for emerging markets stocks.

 

At this stage of the rally, with market expectations rising and the prospect of tighter central bank policies across major markets increasing, selectivity is essential.

"The stability and reform we are seeing in places like China and India are resulting in greater investment opportunities. It’s not just obvious areas like Indian banks and Chinese internet companies, but I am also interested in domestic industries like cement and power, as well as retail companies and consumer-orientated businesses."

Chris Thomsen
Portfolio Manager

Emerging Markets Have Only Just Begun Making Up Ground

Rising Middle Classes, More Stable China Suggest Developing World Has Room to Run

Sources: Capital Group, MSCI, RIMES. Data represents cumulative rolling three-year total returns in USD of MSCI Emerging Markets Index versus the MSCI World Index through 12/31/17.
 

The rally in emerging markets equities is more than 20 months old, with stocks up 76% since a trough in early 2016. Is the rebound getting long in the tooth? It really could just be getting started. An expanding global economy, strengthening currencies and robust demand for technology-related components all bode well for emerging markets. A synchronized global recovery is an ideal environment for emerging markets, similar to the period that lasted from 2003 to 2007.

Amid the ongoing rebound, overall valuations are still attractive from a historical basis and compared to developed markets. For instance, China, Taiwan and Brazil all trade around 13 times projected earnings over the next year, compared with 17 times estimated earnings for the MSCI World Index. Company cash flows are also increasing, which could lead to higher earnings revisions. Corporate profits are forecast to climb 13% in 2018, and historically rising profits have been good for share prices.

 

An improving global economy and dollar weakness can be tailwinds for companies in a broad range of industries, from information technology to consumer goods to financials and commodities exporters. For example, Chinese internet giants Tencent and Alibaba could benefit from rapid growth in mobile commerce and financial services. Banks with solid consumer lending businesses may also benefit from stronger global growth.

"In today’s emerging markets, there are some very strong technology companies that deliver e-commerce services in a very efficient fashion and the adoption rate is high. Chinese internet businesses are now leading innovation in financial services and other areas, a divergence from the past."

Shaw Wagener
Portfolio Manager

Signs of Maturity Emerge in China and Emerging Markets

As the Market Has Shifted From Commodities to Tech, Volatility Has Declined

Sources: MSCI, RIMES as of 12/31/17. Commodities includes energy and materials sectors. Technology includes information technology sector. Standard deviation is for rolling 10-year periods.

Emerging markets have shifted from smokestacks to smartphones. Back in 2008, energy and materials companies dominated the MSCI Emerging Markets Index with a 38% weighting, and many of these firms were state-owned enterprises that were more susceptible to infrastructure-driven booms and busts.

Chinese technology-related firms are now the biggest companies by market value in emerging markets as mobile phone usage is accelerating and internet penetration rates are rising. Along with middle class growth, these developments are changing consumption patterns and delivery methods for financial services.

This "tech-tonic" shift over the past decade (information technology now accounts for 28% of index weight) has also come with a decrease in volatility as cyclical, commodity-oriented companies are no longer index heavyweights.

 

Look for growth in the technology sector to be driven further by demand for handheld electronic devices and mobile-focused services among the large populace of China and India. Some Asian companies, including Taiwan Semiconductor and Samsung Electronics, have also developed specialized knowledge in areas of semiconductors and are key cogs in the global technology supply chain.

 

China Deftly Manages Economic Transition

Overall GDP Has Slowed, but Consumption Growth Is Still Accelerating

Source: Thomson Reuters as of 9/30/17.
 

There seems to be no shortage of worries about China, ranging from debt levels at state-owned enterprises to a potential trade war with the U.S. to an overheated real estate market. That said, China appears to be deftly managing its economic transition to a services-led economy, sidestepping a much feared hard landing through targeted stimulus measures and moves to curb capital flight.

President Xi Jinping enters his second five-year term with a firmer grip on his power and control over the direction of the economy. Measures on Xi’s agenda include consolidating heavy industries, curbing pollution, managing financial risks and supporting technological innovation.

Consumption remains brisk. Housing demand is strong despite government restrictions aimed at curbing speculation. Home purchases should support consumer spending in areas such as household appliances and furniture. Meanwhile, internet heavyweights Tencent and Alibaba continue to report robust sales and profit as consumers gravitate to their wide-encompassing mobile services platforms.

 

The Chinese corporate sector looks to be in good shape. While Chinese stocks have surged over the last 12 months and valuations have risen, forward earnings expectations are rising on an expected recovery in cyclical industries. Profit forecasts are further supported by improving cash flows and debt service ratios. In China’s current economic and political climate, the kinds of companies that could thrive are select technology firms, health care providers and financial services companies.

What This Means for Portfolios

Maintain exposure to emerging markets companies poised to benefit from rising consumer purchasing power and broader adoption of technology. But be prepared for elevated volatility. Go to our Portfolio Playbook for more detail.