Schroders Emerging Market Lens Q4 2024: your guide to EM valuations
As Fed rate cuts and optimism towards China reinvigorate sentiment towards EM, how do valuations look?
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Emerging market (EM) assets enjoyed a strong Q3, as the Federal Reserve (Fed) kicked off an interest rate cutting cycle, and as Chinese policy announcements (and hopes for fiscal stimulus) reinvigorated market sentiment. This has seen a turnaround in market flows to the asset class, with aggregate net inflows for EM bonds, and particularly EM equities for September and early October. EM bonds have seen fairly persistent net outflows since 2022, and foreign investor participation in various EM remains low versus history.
In this edition of the EM Lens we review the performance trends and drivers of EM stocks and bonds year-to-date, and assess valuations. The lens includes separate EM equity and debt chartbooks/presentations, packed full of data and insights, help you navigate the world of emerging markets. The aim here is to provide an unbiased top-down view of markets.
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How have EM stocks performed so far this year?
EM equities outperformed DM in Q3 and has now returned a robust 17% year-to-date in US dollar terms, as at 30 September. EM is only modestly behind developed markets (DM) which are up 19%. This is despite a spike in volatility in late July/August amid a US growth scare, which led to a sell-off in IT stocks, and after a surprise Bank of Japan rate hike triggered an unwind in carry trades.
Read more: China: stimulus arrives… more needed
EM equities were notably strong in September as China announced further monetary policy easing, and pledges from a Politburo meeting raised hopes for fiscal stimulus. Meanwhile the Fed cut its policy rate by 50bps. China’s sharp rally amplified EM Asia performance this year, which had been underpinned by Taiwan and India, and the region has moved ahead of DM. South Africa has also generated a strong gain. With inflation falling into target range, and the Fed starting to ease, South Africa’s Reserve Bank cuts its policy rate in September. Ongoing stability in the new Government of National Unity has also bolstered market confidence.
September rally catapults China from laggard to leader YTD
Return indices to 30 September 2024, rebased to 100 on 31 December 2023
Note: EMEA is Europe, the Middle East and Africa. Source: LSEG Datastream, MSCI, Schroders Strategic Research Unit, as at 30 September 2024. All returns rates shown in USD terms. Past performance is not a guide to future performance and may not be repeated.
By contrast, Latin American markets continue to lag, notably Mexico and Brazil, with currency weakness a drag. Domestic policy concerns have created uncertainty in both markets. In Mexico this relates to the government’s near majority in both houses of congress, following elections in June, and concerns around the policy agenda. In Brazil, economic growth has been stronger than expected, amid ongoing loose fiscal policy, leading the central bank to hikes its policy rate to contain inflation.
Most EM sectors have generated double-digit gains year-to-date, led by consumer discretionary and communication services. Materials is the only sector in the red. Despite this, consumer discretionary and energy are the only sectors ahead of their DM equivalent.
EM performance has been quite concentrated for much of this year. This is illustrated by the outperformance of the market cap weighted EM index over the equal weighted EM index. However, this trend started to reverse in the past month.
Index performance concentrated YTD – but this trend has started to reverse in the past month
Source: LSEG Datastream, MSCI, Schroders Strategic Research Unit, as 30 September 2024. All returns rates shown in USD terms.
Past performance is not a guide to future performance and may not be repeated.
How have EM bonds performed so far this year?
EM bonds have generated strong gains so far this year, with a fall in long-dated US Treasury yields, and the start of Fed policy easing proving supportive of performance. Hard currency debt continues to outperform local EM and US corporate debt, but local started to close the gap in Q3, aided by EM currency appreciation versus the US dollar.
Year-to-date, total return (USD)
Past performance is not a guide to future performance and may not be repeated. Note: Local currency = US dollar for all apart from local EMD which is in the relevant local EM currency. Source: Schroders, LSEG Datastream, JP Morgan, Schroders Strategic Research Unit. Data as at 30 September 2024.
In hard currency EMD, the high yield (HY) sub-index (+12.3%) remains the fast rabbit, but the investment grade (IG) sub-index (+5.1%) has also generated a solid gain so far this year. Within HY, Ecuador (+70%), Argentina (+52.0%), and Pakistan (+41.0%) have generated some of the strongest returns. In corporate hard currency EMD, the trend remains similar with HY comfortably outperforming IG.
Local EMD had faced a more challenging first half of 2024, owing to US dollar strength. However, local debt rallied sharply in Q3, closing some of the gap to hard currency, underpinned by currency appreciation versus the US dollar. This was largely driven by Asian currency appreciation.
The surprise rate hike from the Bank of Japan, subsequent yen rally and unwind of carry trades negatively impacted various EM currencies, notably the Mexican peso. Policy uncertainty in Mexico, and also in Brazil, added to uncertainty.
Most EM currencies appreciated in Q3, but the YTD picture remains mixed vs. the US dollar
EM FX performance YTD, as at 30 September (%)
Past performance is not a guide to future performance and may not be repeated. Source: Schroders, LSEG Datastream. Data as at 30 September 2024.
What do valuations look like?
Equities
Consensus expectations for EM earnings growth have continued to pick up this year, from a low base after a -4% contraction in 2023. EPS growth of 21% and 16% is anticipated for this year and 2025 respectively.
Headline EM valuations have increased, reflecting improved EPS expectations. Aggregate valuations are above the historical median on price-book (P/B) and, to a lesser extent, 12-month forward price-earnings (P/E). Dividend yield is in line with the historical median. However, larger markets continue to skew the aggregate somewhat, and many EM are cheap versus their own history, using a standardised composite valuation measure, as the heatmap below illustrates.
EM valuation heatmaps – India and Taiwan expensive versus history, but these large caps skew the index average
EM valuation heatmaps – current z-scores¹
¹The z-score is a measure of how far valuations are from historical mean, calculated since January 2000. Excludes UAE, Qatar, Saudi Arabia and Kuwait due to limited data history. Combined figure is an average of trailing P/E, 12-month forward P/E, P/B, and dividend yield. Source: Schroders, LSEG Datastream, MSCI, IBES, Schroders Strategic Research Unit. Data as at 30 September 2024.
Meanwhile, the valuation gap to DM remains wide at 36% discount. This is close to the widest in the past 20 years.
EM/DM 12-month forward P/E discount/premium
Source: LSEG Datastream, MSCI, IBES, Schroders Strategic Research Unit. Data as at 30 September 2024.
Bonds
At the headline level, the hard currency sovereign index spread is in line with its historical median. However, this hides a contrast between the IG and HY sub-indices.
The IG sub-index spread is well below the median and approaching a more than decade low. This has been driven in part by the impact of compositional change. Specifically, the impact of the rise in index weight of the Middle East, which is higher rated and has impacted the valuation picture. The HY sub-index spread has fallen from elevated levels seen in recent years, but remains slightly above its historical median.
In local EMD, real yields are positive almost across the board, and notably so in Latin America. This has been driven by a rise in bond yields, coupled with ongoing disinflation. Taiwan remains an exception here.
Real 10-year yield
Nominal 10-year yield minus annual headline or core inflation. Turkey’s real 10-year yield omitted from the figure. Source: Schroders, LSEG Datastream. Data as at 30 September 2024.
We previously highlighted that net credit rating changes had turned positive on a 12-month moving average bass. These remain in positive territory; the longest period in the last decade.
Sovereign hard currency index net credit rating upgrades/downgrades
Past performance is not a guide to future performance and may not be repeated. Weighted by number of issuers, not size of issuer. Source: Schroders, Bloomberg. Data as at 30 September 2024.
There are currencies which appear undervalued in all three EM regions, but the degree of value varies significantly…
The Czech koruna, Uruguayan peso, and to a lesser extent Romanian leu, Polish zloty, and Uruguayan peso are above their long term and five-year averages on a real exchange rate basis. The Turkish lira, Brazilian real and South African rand rank as cheapest relative to their long-term average.
Some currencies appear significantly undervalued relative to their long-term average
Real exchange rate: deviation from average
Source: Schroders, LSEG Datastream. Data as at 30 September 2024. Real exchange rate is the nominal dollar exchange rate deflated by the consumer price index (CPI) of each EM country vs. US. Long-term average is since January 1995.
Risks to monitor for EM
The outlook for US growth and inflation remains important for EM, given implications for yields and the direction of the US dollar. Whilst the Fed has commenced policy easing, there is a risk that market expectations for rate cuts are overdone, and that resilient data drives a slower or shallower cutting cycle. This could lead to US dollar resilience, at least on a near-term basis. Rate cuts, together with the twin-deficits could weigh on the currency further out.
Read more: What impact will the US election have on emerging markets?
The US presidential election on 5 November, and rising geopolitical tensions present additional risks in the near-term. There are clear policy differences between Trump and Harris, with implications for the path of the US dollar, as well as foreign and trade policy. Meanwhile, the conflict in the Middle East and Russia’s invasion of Ukraine bear close monitoring. These have the potential to impact energy and food prices and could pose a risk to inflation. US-China relations are a further risk to consider.
Meanwhile, the potential for additional policy support in China, namely fiscal stimulus, presents potential upside risk for EM.
Read more here…
More detailed analysis of EM equity and bond market valuations can be found in the dedicated EM equity and EM Lens packs. These are available via the links below.
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