Outlook 2018: Emerging market equities
The MSCI Emerging Markets Equity index has returned 35% (USD return) year-to-date, benefiting from attractive valuations and investors’ relatively light positioning after strong outflows in 2013-2015.
The rally has been led by the uplift in global trade, underpinned by a synchronised recovery in global growth, and US dollar depreciation. This environment has supported an improvement in corporate return-on-equity (ROE) and positive earnings surprises. Strong performance from technology stocks has been a further feature of performance this year.
EM economic growth to remain strong
Schroders expects global growth to be sustained at 3.3% in 2018, marginally higher than the 3.2% expected for 2017. This should continue to support global trade, which is positive for emerging markets (EM). EM are forecast to grow at an aggregate 4.9% in 2018, in line with 4.9% anticipated this year.
China’s economy is projected to expand at a robust rate in 2018. However, we expect the pace of growth to decelerate to 6.4% from 6.8% in 2017, given a tightening of monetary conditions. This is an outcome of a positive move to address regulatory arbitrage and risks in the financial system. We welcomed the emphasis on the quality of growth and addressing structural risk at the recent Party Congress. Nevertheless, the deceleration in Chinese growth is likely to act as a modest drag on global trade.
Elsewhere, we expect continued economic recovery in Russia and Brazil. In Russia, record low inflation is likely to provide room for the central bank to continue to ease monetary policy. This should stimulate consumption and investment.
In Brazil, there are signs that the recovery is widening and lower interest rates have helped consumer and business confidence. The pace of improvement from here may depend on whether a credible path to fiscal stability is established via the successful legislation of pension reform. Politics is therefore likely to remain important, particularly given that a presidential election is scheduled for October 2018.
Strong growth in the Central European emerging markets of Poland, Hungary and the Czech Republic is likely to persist. An expected broadening in the eurozone economic recovery should continue to be beneficial. The reduction in spare capacity is leading to the re-emergence of inflationary pressure and we are moving into a period of early stage monetary tightening, which we expect to be supportive of banks’ profitability.
We expect growth in India to be supported by a bank recapitalisation that should enable improved credit extension as we move through 2018 and 2019. In addition, we are likely to see some fiscal support for growth in advance of the 2019 elections.
Valuations no longer cheap but returns recovery to continue
There has been a trough in the returns cycle and return-on-equity is now recovering. This is supported by improved economic conditions, in combination with prior corporate action on capital expenditure and operational efficiency. We have also seen a turn in some EM country credit cycles, which are normally multi-year in nature.
We believe there is limited prospect for multiple expansion in the next 12 months. The aggregate price-to-book and price-to-earnings ratios are now slightly above their long-term averages, so the market is anticipating an ongoing returns recovery and earnings per share (EPS) growth. We expect EPS growth of 10-15% in the next 12 months.
On a relative basis, valuations remain attractive. The MSCI Emerging Markets index trades on 12.8x forward price-to-earnings ratio (PER), a discount of 24% compared to the MSCI World index.
We continue to think there is a bias for US dollar weakness over the medium term. US dollar depreciation is highly correlated with EM equity outperformance and we believe that EM currencies, excluding the Chinese renminbi, remain undervalued. But the US dollar could continue to see support moving through the first half of 2018 given ongoing US monetary tightening and potential fiscal reform and stimulus.
The risks to EM growth
There are three key factors which could potentially weigh on the positive outlook for EM next year:
- China slowdown
In China, the rapid increase in debt over the past ten years has increased economic and financial risks. The challenge for the government is in achieving growth targets while containing these risks.
We are not expecting a sudden and material slowdown in China’s economy. Corporate debt is elevated at 170% of GDP, but of this 110% relates to state owned enterprises. The debt is largely funded internally due to a high domestic savings rate. Control of the banking system and considerable influence over the real economy also provides the authorities with levers to manage growth.
However, the authorities acknowledge the need to address financial system risks. There will be an ongoing push to improve the coordination of financial system regulation. As a result of measures taken, credit growth is likely to slow in the coming years and there is likely to be an acceptance of slower economic growth on a medium-term horizon.
It is unclear what pace of slowdown will be acceptable and in any case the authorities can only direct but not fine-tune the pace of growth. Consequently there remains a risk that growth in China could slow faster and further than expected on a near term horizon. Although this would not presage a crisis due to ongoing Chinese policy flexibility, it could have an impact on global growth expectations and commodity prices.
- Global liquidity tightening
We remain mindful of monetary policy normalisation from developed market central banks. Our expectation is that developed market central banks will remain sensitive to global economic conditions and exercise caution as stimulus is withdrawn – they are normalising policy because they can.
- US trade policy
The prospect of protectionist US trade policy remains a concern, notably in relation to renegotiation of the North American Free Trade Agreement. Aspects of the US negotiating position are unlikely to be acceptable to Mexico and Canada. The resulting uncertainty for Mexico may impact market sentiment, corporate investment appetite and the medium term outlook for trade. There may also be negative consequences for wider market sentiment towards EM equities.
Click here to read more articles in our Outlook 2018 series.They include Outlook 2018: Emerging markets debt absolute return and Outlook 2018: Emerging markets debt relative.
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