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16.09.2016 | 16:25

BNP IP: EM equities outperformance - sprint or marathon?

This is the first time that EM equities have outperformed their DM rivals by such a margin over an equivalent timeframe since they began to fall behind developed equities at the start of October 2010. By Patrick Mange, Head of APAC & EM Strategy, BNP Paribas Investment Partners.

So far this year to 6 September, emerging market (EM) equities have outperformed their developed market (DM) peers by about 11.5% in US dollar terms, based upon a comparison of the MSCI EM and MSCI DM total return USdollar indices. This is the first time that EM equities have outperformed their DM rivals by such a margin over an equivalent time frame since they began to fall behind developed equities at the start of October 2010. While there have been other instances of EM equities outperforming DM equities over the last six years,t hese have invariably been followed by prolonged corrections, as we can see in chart 1.

So with the thought “Once bitten, twiceshy!” in mind, investors are increasingly asking themselves whether the current EM outperformance will prove – as it has so often in the past – to be a brief, spirited but short-lived, sprint or turn out to be a marathon run that can last. Here, we briefly provide our views, taking into account our previous ideas. Indeed, this April, we strongly endorsed overweighting EM over DM, not just tactically, but over a longer time horizon (cf.: Will the monkey smile on emerging markets? - April 2016). We confirmed this position in July (Brexit doesn’t mean an EM exit! - July 2016), taking into account the decision of the UK to leave the EU. We still hold this view, while acknowledging that a more uncertain US interest-rate outlook since the late August annual gathering of central bankers at Jackson Hole might trigger profit-taking on this so far profitable trade.

Firstly, this ’strategically’ constructive view is based on the fact that growth in emerging economies, in both real and nominal terms, has once again started outpacing that of developed countries after lagging it for about five years until Q3 2015. Economists and public institutions are forecasting that emerging economies’ GDP will expand more rapidly than the output of developed markets both this year and next. Interestingly, theconsensus sees the growth gap widening both because GDP growth in DMs is slowing and – more importantly– because it is accelerating in EMs.

Furthermore, it is domestic rather than external drivers that are judged to be contributing the most to the expansion of EM economic activity, in the form of increased public investment, stronger consumption and a developing services sector. Admittedly, it is Brazil and Russia, which seem set to move out of deep recessions in 2017, that are likely to be the main contributors to EM’s growth acceleration. Indeed, barring China, which admittedly is a heavy weight in its own right, most other emerging economies are forecast to expand faster as we move into next year. If history is a good guide, the relative performance of emerging equity markets versus developed ones should be well supported by a sustained widening of the growth differential (chart 2), all themore so as EM equities are still trading at big discounts to their DM peers in price and valuation terms.

The contraction of the growth differential between EMs and DMs in recent years was a greater headwind to EM equities as it coincided with a slide in commodity prices. However, the recent news is more positive on this front, too. In fact, most experts appear to agree that the drop in commodity prices, notably those of crude oil, is behind us. Given the still large supply overhangs in various commodities, the consensus sees prices remaining volatile and moving up only gradually, while supply and demand slowly rebalance. Crude oil prices, for instance, which dropped to a low of around USD 22 per barrel at the end of this January and have moved back to around USD 48/bbl at the time of writing, are expected to grind slightly higher to around USD 52/bbl by the middle of 2017.

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