Three signs for navigating emerging markets

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If investor sentiment on emerging markets was a traffic light, it would be flashing amber. Given the myriad sources of geopolitical uncertainty that have cropped up on the horizon, it would seem only prudent to proceed with caution. Nevertheless, the path ahead would appear to be compelling for those willing to navigate the road.

Shrugging off a frankly challenging 2013, emerging market equities have been on a relatively steady upward trajectory in recent months. In July, the EM index posted its best monthly performance since December 2012.  Investors have rewarded the asset class with USD 8 billion in inflows into EM equities in just that month, the fourth consecutive month of positive flows.

In fact, compared to other global assets classes, emerging market equities have been a top performer year-to-date. It doesn’t feel like this has been the case for many market participants.  The key question that investors face is now whether they should be rethinking their holdings and adding more to their emerging market allocations before the opportunity is entirely clear?

In our view, there are three primary catalysts that investors should be monitoring for a signal on the road ahead.

First, look for stabilisation across emerging market currencies. This is a signal of trade balance improvement as emerging market earnings catch-up to the developed world. That is starting to happen as we seeing the beginnings of an earnings recovery.  The chart below shows implied forward earnings-per-share growth, with markets such as India and Korea leading the way on expected earnings optimism.

Second, look for emerging markets to ‘recouple’ with developed markets. In recent years, EMs have struggled relative to their developed market counterparts because of the widening gap in economic performance. Average emerging market earnings have disappointed expectations, not keeping up with developed markets and causing their relative market performance to suffer. This is of course a divergence from the normal long-term pattern of correlation, in which the respective economies generally moved together. However, there is evidence this is starting to turn. Correlations in forecast GDP growth for the next 12 months are illustrated below, showing we may be approaching an inflection point. Manufacturing-intensive emerging market exporting countries are taking the lead in showing signs of life and already undergoing ‘selective recoupling’ as they benefit from recovering demand.

Third, investors should look for continued improvement in emerging markets earnings expectations. As emerging market companies return to greater profitability, this should boost margins. As the forecasts for these companies grow more rosy, that should have a tangible positive impact on prices.

That final catalyst in our view should be considered alongside valuations, which are not a catalyst per say but certainly an important traffic signal.

When price-to-book (P/B) values have fallen below 1.5x, the MSCI Emerging Markets Index has historically registered double-digit returns over the following 12 months, as illustrated below. In other words, what you pay for an asset class tends to be the defining feature of your return profile. The lower the entry point, the higher the prospective returns.

There are always unforeseen risks in emerging markets and it is an asset class driven more by sentiment and confidence than others. Admittedly there is still no proverbial green light. Can valuations go lower? Can currencies fall below fair value? Yes, they can, but a cyclical asset class with high volatility is a buy in these circumstances for investors with a one-to three-year horizon.

Buying EM is neither obvious nor popular, which may be precisely why today’s markets may offer an opportune entry point for the long-term investor. History teaches that equities rise before economic growth and earnings turn. Those investors who wait for a pickup in earnings and stronger growth miss a substantial portion of the upside that drives the longer-term return profile of a cyclical asset class such as emerging market equities.

 

Richard Titherington is CIO, Emerging Market Equities, J.P. Morgan Asset Management

 

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