Emerging markets: yield, growth, value

When we started to discuss the 2017 outlook, it struck us quite early that many of the key supportive arguments for 2016 will also hold true for 2017.

These arguments are centered around yield, growth and value, all of which are rare in developed markets, but frequently part of the story in emerging and frontier markets.
Separately, we found it intriguing to start thinking about what a dose of developed market reflation would imply. What would happen if investors even mentioned the word inflation, instead of continuous talk about deflation? Eurozone inflation seems to have bottomed out, and is likely to reach 1.4% in 2017.

Yield – emerging markets; the place to be
First of all, we can note the historically abnormal situation where 29% of developed market sovereign debt is trading in negative territory, i.e. investors would nominally lose money by holding these bonds to maturity. This is up from ‘only’ 5% a year ago. Adjusted for inflation by looking at the real rates, the situation looks even worse, with real rates deeply negative. Reflationary policies would aggravate the situation even more, with real yields moving into even deeper negative territory due to higher inflation expectations.

Anecdotal evidence tells us that investors are getting increasingly desperate in the hunt for yield. New instruments based on bundled airplane leases or even revenues from certain pharmaceutical products are being issued. Emerging and frontier markets, on the other hand, offer high real interest rates, and even higher nominal ones. Clearly, investors would take a risk on the currency, but, for example, the Russian rouble has strengthened versus a strong US Dollar during 2016. Russian capital flows for 2017 might be flattish, versus large outflows in the past couple of years, which is supportive for the rouble. Investors currently receive a 8.9% return on a one year government rouble bond, or 3.9% in real terms (when adjusted for inflation).

A key consideration will clearly be whether investors would be willing to take local currency risk. We believe that currencies will show mixed performance during 2017, but on average they should be less volatile than in 2016.
All in all, we think that investors are likely to switch out of developed market bonds, perhaps to equities or emerging market bonds. Developed market interest rates on the longer, and perhaps shorter, end of the curve are likely to be higher than in 2016. Theoretically, this is negative for equities, but we think the rate increase will be modest and more than compensated by flows, i.e. developed equity markets would benefit from inflow from the bond markets. The second step would be flows from developed market equities to emerging. Frontier markets might also see inflows, but that would typically be after flows to emerging markets.

Growth is picking up
It is a fact that on average GDP growth is higher in emerging and frontier than developed markets, and this leads to stronger long-term sales and profit growth of companies. However, what is interesting is to compare the GDP growth differential of emerging and developed markets to relative stock market performance. To make it perhaps a bit more clear – when the incremental increase in GDP growth is larger in emerging than developed markets, then emerging market equities outperform. We expect this pick-up to be significant from 2017 with emerging markets’ GDP growth accelerating to 4.6% from 4.2% in 2016, and if history tells us anything, emerging markets should continue the outperformance that started in 2016.
We can support this argument by looking at the individual markets. Investors are significantly less worried about China and a potential slowdown compared to a year ago. It looks like GDP growth will hold up at around 6-7%. We are expecting that Indian growth will remain stable at around 7.5%. In Brazil, growth is turning from -3.3% in 2016 to 1.0% in 2017. Russia will return to 1.5-2% growth in 2017, compared to a contraction of -0.5% in 2016.
Looking at the stock markets, 2016 is likely to mark the turnaround in aggregate emerging markets earnings with a small positive, after five years of more or less steady decline. Earnings growth expectations for 2017 are 14.6% in USD terms, as MSCI EM EPS rises from USD 63.8 in 2016 to USD 73.0 in 2017. We are also noticing a record large spread between companies in terms of performance and hence earnings growth, something that should be positive for stock pickers.

Value – many markets did perform, is there any value left?
While developed markets are hitting new all-time highs, emerging markets are still trading 22% below their peak levels. The valuation gap has been increasing since 2010; looking at price-to-earnings emerging markets are now trading at 13.5x versus 17.6x for their developed peers. Prior to 2010 and subsequently four years of outflows from emerging markets, they used to trade more or less on par. Having in mind that emerging markets have long-term higher growth, despite arguably higher discount rates, we believe the discrepancy is unjustifiably large and therefore the emerging market discount should significantly decrease.

Conclusion – what could go wrong?
Overall we believe that our three arguments – yield, growth and value – support the case for emerging and frontier markets. The flows are starting to reflect this as well. The risks will likely come from external events. 2016 was an eventful year and we learned to expect the unexpected. 2017 will be more of the same. A number of European elections might have unexpected outcomes, with possibly negative implications for the unity of Europe. We don’t know how Trump will act, in particular in relation to trade policy that could be negative for China. On the other hand, Russia will likely benefit from improved relations with the US. Syria and ISIS are perhaps another problem, or part of the solution if US and Russia could finally start cooperating.
All in all we are fundamental stock pickers and strong believers in that if companies do well, deliver growth then performance will follow albeit with some volatility on the way.

Peter Elam Håkansson – CIO – East Capital