2H outlook: Stay the course on EM post Brexit

Emerging markets have appreciated by 4% in US dollar terms over the first half of 2016, outperforming developed equities by 9%.

The result of the UK 23 June EU referendum has diminished risk appetite and created negative contagion across global asset prices. Nonetheless, in the post-Brexit fallout, we argue that EM equities should prove insulated from what we forecast as an impending UK recession and trimming of expectations for what was an already tepid Eurozone growth recovery.

The direct impact on aggregate emerging markets from Brexit is relatively contained: the UK accounts for just 2.5% of total gross directional exports from MSCI EM countries (or 0.9% of GDP), the UK is the source of 16% of total cross border lending into emerging markets (on an immediate borrower basis), an exposure of 3% of total GDP and 4% of the total stock of gross inward FDI to emerging markets (or 1% of GDP).

Specifically we note the following nine reasons to support overweighting EM: (i) our four factor regression model suggests 17% dollar upside to year-end 2016, (ii) steadily improving absolute and relative margins and return on equity, (iii) EM currencies remain extraordinarily cheap on PPP against history, (iv) evidence of stabilization in Chinese GDP, real estate and earnings, (v) improvement in emerging market relative macro momentum, (vi) rising forecast earnings growth with stabilizing revisions, (vii) capex adjustments and rising free cash flow is boosting payout ratios, (viii) absolute and DM relative valuations offer an attractive entry point, and (ix) global funds remain deeply under exposed to emerging equities.

We consider five principal risks to our view: (i) a Brexit induced structural strengthening in the trade weighted dollar, (ii) a likely UK recession impacts EM exports, borrowing and investment, (iii) a lack of meaningful credit adjustment across EM economies, (iv) we struggle to justify much further uplift in commodity prices, and (v) further managed renminbi devaluation.

Equity Research – Credit Suisse