By Morgan Harting
Emerging markets have performed strongly since their trough early last year. There are still great opportunities in the developing world. But to find them, we think it's especially important to search across asset classes.
The MSCI Emerging Markets (EM) Index has rallied by more than 30% in 2017 through mid-November. Yet, as we head into 2018, emerging markets face heightened geopolitical and currency risk, as well as pockets of overvaluation.
Valuations Are Still Attractive
Still, EM valuations are attractive in the aggregate. Even after this year's gains, the MSCI EM Index trades at a 25% discount to the MSCI World Index of global developed stocks. What's more, the return of EM equities this year has been driven largely by fundamentals. Against a backdrop of solid global trade growth, EM earnings estimates have been revised upward throughout the year. And since only a 10th of EM equity returns to date have been generated by an expansion of earnings multiples, we think there's room for further gains.
Meanwhile, although flows into EM debt funds are on track for a record year, there are pockets of opportunity in higher-yielding EM sovereign and corporate dollar-denominated debt. Local currency debt also appears attractive, as yield differentials between emerging markets and developed countries remain very high.
Many developing countries' fundamentals are also improving. GDP growth across emerging markets is expected to increase by 4.6% in 2018, while inflation is declining or stable in most major markets. This combination puts emerging markets in a "sweet spot," allowing room for potential stimulative policies, if required.
External account balances have adjusted significantly. As a result, EM countries are less reliant on foreign capital and less vulnerable to rising interest rates in developed markets. Meanwhile, reforms and better governance in various counties are further brightening growth prospects across the developing world.
As these improvements help support positive sentiment for EM investors, we think the following opportunities are worth watching in 2018:
The EM Tech Enablers
The rally in EM equities to date has followed a very similar pattern to the US market. About a third of the gain is accounted for by big digital leaders in fields including mobile and e-commerce. Investors have come to view the US leaders - Facebook (NASDAQ:FB), Amazon.com (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (GOOG, GOOGL), collectively dubbed the "FANGs" - as having unassailable positions. Emerging markets have their equivalent - Alibaba Group (NYSE:BABA), Tencent (OTCPK:TCEHY), Samsung Electronics (OTC:SSNLF), Naspers (OTCPK:NPSNY) and Taiwan Semiconductor Manufacturing (NYSE:TSM) - which between them have achieved about three times the return of the rest of the EM equity universe in 2017.
The EM rally could broaden as investors warm to a wider range of companies and sectors that support the growth of these digital leaders, including DRAM producers and electronic component manufacturers in Taiwan and South Korea. These are benefiting from industrial consolidation and better capital discipline, which in turn is supporting rapid growth in cash profits and dividends not yet reflected in earnings multiples.
Large-Cap Chinese Banks
The major Chinese banks trade at half the valuation of their global counterparts, despite delivering superior profitability and twice the dividend yield. Moreover, the business environment for these lenders is improving. Profitability across Chinese companies has strengthened this year - see, for example, the 35% increase among many industrials - which feeds through to lower credit risk for the banks and reinforces the quality of their loan portfolios.
At the same time, Chinese authorities have successfully clamped down on "shadow banking" activities among the country's smaller institutions. This suggests that the efficiency of the financial system is improving: more resources are being channelled into productive activities as opposed to financial engineering. Taken together, these developments reduce risk and drive up profitability for select Chinese banks.
Brazilian Government Bonds
Inflation in Brazil has collapsed, falling from more than 10% in January to about 2.5% in November, opening the way for steady reductions in interest rates, which has boosted bond returns. With 10-year nominal yields in Brazil still at 10%, real yields in Brazil are among the highest in the world, pointing toward continued strong returns for bond investors in the coming year.
Much of Brazil's incipient economic recovery has already been priced into the stock market, which climbed 69% in 2016 and is up another 30% this year, putting it on a punchy multiple of 24 times earnings. We see better risk-adjusted returns at this point in fixed income than in the broad Brazilian equity market, though there are select company opportunities in both equity and credit.
We believe that by looking across asset classes, interesting opportunities can be found in different sectors and countries. Targeting the most attractive opportunities across equity and bond markets can help create a more balanced portfolio - and a smoother pattern of returns for a potentially prolonged EM recovery into 2018.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio management teams.
MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.