Henderson: Will emerging markets continue to recuperate?

Sentiment has shifted since Q1

The current rally in emerging market (EM) equities arose out of a consensual gloom about the asset class in the first quarter (Q1) of this year, and a broader backdrop of a global growth scare and investor revulsion with cyclical commodities. How things change. At the time of writing, surveys suggest that most fund managers are overweight equities and oil and see more tail risks in the major economies and markets rather than the emerging world. However, now that sentiment has shifted, fundamentals are becoming more important. While even a small change in sentiment can be enough to spark a rally in unloved markets, improving fundamentals are ultimately needed to underpin the move and to sustain further advances.

Fundamentals are supportive…

The good news here is that fundamentals remain fairly supportive for EM equities. Global growth is gradually improving, inflation is edging higher, and monetary policy looks set to remain accommodative until the recovery is stronger. Furthermore, 2016 is shaping up to be a pivotal year in terms of the relative macroeconomic momentum of emerging economies compared to the developed world. After a handful of years in which the emerging economies saw their growth superiority over the major economies diminish, this growth gap is now beginning to widen again. That is evident in both top-down indicators, such as gross domestic product and bottom-up measures, like company earnings forecasts. These indicators provide reliable frameworks for determining the underlying trend in the relative performance of EM assets. They gave clear signals to be wary of EM exposure from the late 2000s, until they began to turn up again in mid-2015, encouraging us to rebuild exposure to EM equities in our multi-asset funds.

…but risks remain

Despite the improving fundamental backdrop, the recovery in EMs is still fairly fragile and vulnerable to setbacks. The recuperation could be disrupted by anything that challenges the ‘goldilocks’ scenario of improving growth and continued monetary accommodation from the central banks. There are risks on both sides. As we saw in Q1, any kind of global growth scare would probably shake EMs hard, as it would undermine the recovery in commodity prices and reopen some of the structural concerns that still lurk in the background. While continued positive growth surprises in the emerging economies would naturally be positive for EM assets, a rapid increase in US macroeconomic momentum could be problematic, given the potential for this to trigger a taper-tantrum-style generalised de-risking.

In addition to these general threats we see a few specific threats to the rally in EM assets:

The US election is a significant binary risk for EM assets. The key issue here is the looming threat of trade protectionism associated with a Donald Trump victory. A Trump victory would probably usher in a significant period of global uncertainty with markets focused on the possibility of a full trade war. This could certainly weigh heavily on global risk appetite and be a massive setback for the rehabilitation of EMs. It is quite plausible that a Trump victory would completely extinguish this year’s recovery in EM assets.China: while fears about financial stability in China were a key driver of the global risk sell-off in Q1, the stabilisation of Chinese macroeconomic momentum has been a key theme since then. Still, concerns persist about the sustainability of Chinese growth and occasional setbacks in confidence on this front are to be expected – the problems are structural, after all.

Commodities: anything that disrupts the recovery in commodities would weigh heavily on EM assets.

Valuations: look beneath the surface

EM equities in aggregate are not notably cheap: valuations are neutral, at best. However, aggregate valuations conceal the striking bifurcation of EMs that has progressively widened in recent years, with stocks perceived as being defensive or high quality becoming more and more expensive while unloved sectors and markets languish on low single-digit price-to-earnings multiples.

Still, over the long term, about 25% of emerging market equity returns have come from the embedded currency exposure. The good news here is that, while EM equity valuations look broadly neutral, EM currencies look cheap relative to macroeconomic fundamentals, offering potential upside to holders of EM debt or equity.

Die Wertentwicklung in der Vergangenheit ist kein zuverlässiger Indikator für die künftige Wertentwicklung. Alle Performance-Angaben beinhalten Erträge und Kapitalgewinne bzw. -verluste, aber keine wiederkehrenden Gebühren oder sonstigen Ausgaben des Fond.

Die Informationen in diesem Artikel stellen keine Anlageberatung dar.