Can The EM Equity Revival Last?

by: Kate Moore

Emerging market (EM) stock performance has impressed in 2017. Kate weighs in on whether the opportunity has passed or there's still time for investors to get in on the action.

The outperformance of emerging market (EM) stocks in 2017 has investors asking: Is this a game of catch-up or the start of a multi-year winning streak? We lean toward the latter and see the EM equity revival in early innings.

The underlying fundamentals for EM equities are improving after five years of declining profitability and weak earnings growth. Much attention goes to China, but we see opportunities well beyond this EM powerhouse and detail them in our Global equity outlook Early innings for emerging markets. Here's a quick look at just a few of the forces we believe are offering support for EM equities today.

Structural reforms

Structural reforms in labor and banking can cause pain in the near term, braking growth. But in the long term, well-targeted reforms can bring gains and lead to higher profitability, we believe. True structural reform improves the ease of doing business (reducing friction and transaction costs), provides greater flexibility for companies (particularly on hiring and firing), and supports aggregate demand. This feeds into domestically driven earnings growth.

We are encouraged by a few countries making big headway on the reform front - with positive implications for equity markets and future earnings. In Brazil, labor reform passed earlier this year gives companies more flexibility in managing their workforce, potentially leading to lower labor expenses. Elsewhere, India has seen some of the most substantial reform progress among EMs, kicked off by Prime Minister Narendra Modi's election in 2014. One example: Demonetization last November removed a big chunk of cash from circulation in an effort to crack down on tax evasion and corruption. Company margins in India have been challenged as the government has undertaken reforms, but they are slowly showing signs of improvement amid lower expenses and inflation.

Stimulative monetary policies

Many EM central banks are able to cut policy rates even as the Federal Reserve normalizes and other developed market central banks weigh cutting back accommodation. We calculate seven major EM central banks, including Brazil's and India's, collectively delivered more than 1,000 basis points in rate cuts through October of this year. Mexico was the only major EM central bank to increase rates in 2017. Developed markets (DMs) are heading in the other direction. The key reason for the divergence: EM disinflation.

Case in point: Brazil's inflation rate has tumbled from 10.7% at year-end 2015 to 2.5% today, according to Haver Analytics. And rate cuts have been dramatic, with the central bank's Selic rate dropping over the past 12 months from 14.25% to 7.50%, its lowest since 2013. We see rates ending the year at 7%, with another 50 basis points of easing in the first quarter of 2018. In India, central bank policy rates of 6% are their lowest since 2010, while Haver data show inflation has declined from 13.4% in January 2010 to 3.3% now. The upshot for equities: Reduced cost of funding supports the corporate sector and should stimulate spending and investing.

Still a relative value

Strong EM equity performance has largely followed a broad-based earnings recovery over the past 18 months, after earnings of MSCI EM Index companies had slid 7% a year since 2011. Both new and old economy sectors (tech, industrials, energy) have contributed. Yet EM stocks do not appear expensive on a relative basis. MSCI EM valuations are at their highest since 2010, but 24% below DMs.

Net flows into EM equity funds are on track to reach $70 billion this year, or about 6% of assets under management (AUM), as illustrated in the chart below. This is a solid reversal from the $114 billion in outflows over the last four years (amounting to 14% of AUM). And yet fund flows and price momentum are not signaling mania, research from BlackRock's Risk and Quantitative Analysis team shows.

The risks to our view

Risks include the U.S. dollar strengthening faster than the gradual appreciation we expect and a bigger-than-expected slowdown in China. There's also the potential for tense trade relations, and elections and populist politics undermining reform agendas. All of these risks are real but do not overpower what we see as a solid investment case for EM equities. Bottom line: We believe the recent outperformance is the start of a longer trend.

This post originally appeared on the BlackRock Blog.