Emerging markets have seen significant divergence in performance thus far in 2015, both between and within individual markets. Still, the overall asset class has continued to struggle, with heightened risk aversion and significant capital outflows given slower GDP growth in China, currency devaluations, expectations for U.S. interest rate hikes, and, for raw materials exporters, pressure from low commodity prices. Looking ahead, although risks remain, we believe recent underperformance may have troughed, particularly in light of compelling valuations in a benign global economic climate.
Growth Continues to Be Scarce
While macro events have recently dominated markets, the fundamental case we've made for years is worth revisiting. Emerging market countries make up half of global GDP and, despite weakness, have been a significant driver of incremental growth in 2015; emerging markets' debt load, at the national and consumer levels, is far below that of their developed market counterparts. Given subdued global growth, we believe emerging markets with a domestic orientation, especially in Asia, may continue to be advantaged.
We have a long-standing preference for domestically focused businesses and sectors, but remain cautious towards exporters. For example, the defensive characteristics of consumer staples businesses, along with globally low valuations, have led to the sector trading at a significant premium to the rest of the emerging markets.
Commodity Exporters vs. Importers
Commodity prices have remained depressed due to China's slowdown and new capacity. As such, commodity exporting markets like Brazil and sectors including materials, industrials and energy have faced headwinds. Still, we think the sell-off in commodities and cyclical stocks may offer select opportunities in a few quality-oriented names.
Of course, low raw material prices (and related low inflation) are positives for commodity importers. For these markets, inflation and fiscal balance sheets have improved, and both manufacturers and consumers have benefited from lower input costs. Even if prices stabilize, we believe they are likely to remain relatively low, which could provide a tailwind for consumers and producers with pricing power.
Inflation Is Generally Down, Reflecting Lower Commodity Prices
Consumer Price Index (year over year % change)
Source: Bloomberg, data as of November 2, 2015.
After initial euphoria in markets such as India and Indonesia, where new leadership was chosen to drive reform, investors are adjusting to the reality that change is tougher to implement in large democracies. Elsewhere, we see China's shift from an unprecedented high GDP growth rate as positive, because the country is moving from dependence on fixed-asset investment to a focus on consumption. To us, this represents a move toward more sustainable growth, and may create compelling long-term domestic investment opportunities. If that is the case, low valuations, stabilization and more sanguine sentiment could drive upside for bottom-up investors in various niche areas.
Areas for Vigilance
While our expectations are somewhat optimistic, the risks remain. The market continues to focus on two themes: the possibility of further slowing in China, and the potential effects of Fed rate increases. On the first topic, we think China's slowdown is to be expected considering its shifting economic mix, and that the market needs to "get over" its obsession with China's percentage growth rate, given its place as the world's second-largest economy. On the second, although economies that are less sensitive to Fed policy may do better, we believe that currency depreciations are generally behind us, suggesting the potential for improving current account balances.
In our view, recent downward earnings revisions were primarily related to commodity and cyclical factors. While emerging markets companies were not used to slowing revenue growth, they have finally adjusted to the reality. With capital expenditures stabilizing, a focus on margins and cash flow may start to materialize. Current valuations are factoring in a bearish scenario, giving us scope for cautious optimism.
Emerging Markets Offer a Substantial Valuation Discount on Projected Growth
Forward Price/Earnings-to-Growth Ratio
Source: Bloomberg, data as of September 30, 2015.
Although the risks remain elevated, the key appeal of emerging equity markets - the potential for higher growth - seems particularly valid in a slower-growth world. We see potential for outperformance in identifying the markets and stocks that appear well positioned to deliver on that potential, led by domestically-oriented businesses with pricing power and good earnings visibility.
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