Emerging Markets: Don't Be Spooked By Bleak Headlines

|
Includes: ADRE, CHN, CN, CXSE, DBEM, DMRE, EDBI, EDC, EDZ, EEM, EET, EEV, EIDO, EMEM, EMF, EMLB, ESGE, EUM, EWEM, FCA, FEM, FLCH, FLQE, FXP, GXC, HEEM, IDX, IEMG, IF, ISEM, KEMP, KGRN, MFEM, MSF, PGJ, PPEM, RFEM, ROAM, SCHE, SPEM, TDF, TUR, VWO, WCHN, XPP, XSOE, YANG, YINN, YXI
by: AllianceBernstein (AB)
Summary

EM capital markets snapped back sharply early this year.

The mood at China's stock exchanges has already brightened considerably, as measured by several momentum benchmarks.

While the challenges are huge, Turkey's recovery potential is compelling.

Although the near-term global growth outlook remains uncertain, there are still enticing pockets of opportunity to be found in emerging markets.

By Morgan Harting

Signs of a recovery in emerging markets early this year have given way to worries about China's economic slowdown and sluggish growth in Europe and Japan. But beyond the negative headlines we think many risks that weighed on the market last year have faded and the earnings outlook is relatively strong.

Will the 2019 Rebound Continue?

Last year was not kind to emerging-market (EM) investors. Escalating trade tensions between China and the US, as well as higher Fed rates and a strengthening dollar led to a painful correction in EM assets, particularly stocks.

EM capital markets snapped back sharply early this year. With Fed rate-hike expectations evaporating, rising hope for a US-China trade agreement and the prospect of China stimulus, EM returns improved considerably in January but paused in February and March. We expect the recovery to continue, though it will inevitably be a bumpy ride.

Relative valuations and corporate earnings growth prospects give us further confidence. The valuation of EM stocks is about a third of their developed-world peers. That discount is particularly compelling given the faster expected earnings growth in EM over the next 18 months compared with developed markets. While earnings revisions are coming down everywhere, EM earnings are expected to grow by 10% over the next 18 months, outpacing global earnings by about two percentage points. And corporate earnings margins in the developing world are well below their developed-world peers, leaving considerable room for expansion.

The greenback's robust performance in 2018 has been painful for external EM financing needs. But the US dollar has now reached an extreme valuation level, in our view. In fact, its valuation versus a trade-weighted basket of currencies has not been this high since the mid-1980s. We believe this trend is unlikely to continue and may well reverse, providing yet more support for EM assets.

If history is any guide, EM stocks may deliver strong returns in 2019. That's because in the past, when EM companies' earnings significantly outpaced returns in a given year, the market often rallied in the following year.

Here are three important EM hotspots that may offer surprising investing opportunities:

China: Tide Appears to Be Turning

The US and Chinese administrations have toned down their aggressive rhetoric in the ongoing trade dispute. Even if a full-blown agreement may not be imminent, the diminishing prospect of further escalation is a positive development. In fact, the mood at China's stock exchanges has already brightened considerably, as measured by several momentum benchmarks. At the same time, Chinese stocks are extremely cheap when looking at price/earnings and price/book ratios. Fiscal stimulus and the increasing credit impulse are making an impact, too.

Turkey: Looking Beyond the Turmoil

Turkey suffered from a well-publicized currency and stock market meltdown over the summer of 2018. Galloping inflation and political interference with the central bank eroded investor confidence. But authorities have since taken more forceful action to address inflation and other macroeconomic imbalances, spurring stabilization and the beginning of a recovery in the stock market.

The adjustment to equity and currency markets was extreme, leaving risk premiums among the highest across emerging markets today. However, the yield spread of dollar-denominated Turkish bonds versus US Treasuries has started to recover and now looks closer to long-term averages.

While the challenges are huge, Turkey's recovery potential is compelling. In historical perspective, EM countries that experienced currency crashes like Turkey's last year have bounced back sharply over the subsequent two years, as their economies stabilized and investors waded back in.

Yet, Turkish stocks and the lira are likely to remain volatile because of ongoing investor scepticism about the government's commitment to coherent policies, as recent renewed market turmoil illustrates. So taking an outsized position would be imprudent. But in the context of a global EM portfolio with other diversifying sources of return and volatility control, an appropriately sized allocation to select Turkish stocks and the currency is likely to be a meaningful contributor to returns, in our view.

Indonesia: Bonds More Attractive than Stocks

While we see more upside potential in stocks than bonds in most EM countries, the reverse is true for Indonesia. Stock valuations in Asia's third most populous country are comparatively rich, but the fiscal picture is encouraging, and the political situation stable, giving us confidence that Indonesian bonds can add stability to a diversified EM portfolio.

Emerging markets will always be quite volatile by their very nature, and 2019 should be no exception. But investors with an integrated and differentiated view of the various regions and asset classes should be rewarded for their tenacity in the long term.

Pockets of Opportunity

Although the near-term global growth outlook remains uncertain, there are still enticing pockets of opportunity to be found in emerging markets. We believe that there could be surprising good news to come for EM investors which would help support further advances, particularly in markets that were hit harder last year.

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.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.