Emerging markets are back in vogue following an exodus from the asset class last year……
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• Emerging market flows return after last year’s exodus
• Relative valuation favours emerging market equities
• Currency and commodities tailwind
Emerging markets are back in vogue following an exodus from the asset class last year. Year to date the MSCI Emerging Markets Index is up by 15.5%, whereas the MSCI World Index is up a mere 6.4%, as the outlook for EM has improved coupled with accommodative monetary policies globally. This week we take a look at what has driven the turnaround and why investors are finding it compelling.
“I still know what you did last summer”
Emerging market equities were the ‘pain trade’ of 2015 as concerns over a Chinese hard landing painted a bleak outlook, and the start of the US Federal Reserve’s interest rate hiking cycle put additional pressure on investor sentiment that was already fragile. What followed was an aggressive repositioning amid the mounting headwinds as investors headed for the exits. Given China’s significance for the performance of EM economies and commodities, signs of improvement there have been a welcome indication of near-term stabilisation – the August Caixin Composite PMI came in at 51.8 having moved back into expansionary territory since March. Figure 1 shows the performance of EM equities and the sharp sell-off last summer, which was also coupled with outflows (over the same period). Since bottoming out in January 2016, EM equities have pared back on the lost ground; however, it is interesting to note that the market is still near the trough levels seen around the ‘Taper Tantrum’ in 2013 when the Fed was starting to unwind its easy monetary policy. Therefore, coming from a low base of investor positioning, flows into the asset class have been strong and have responded to the re-pricing of fundamentals and shallower rate hike path by the Fed.
Favourable Valuations versus Developed Markets
One of the main reasons flows into EM equities have been strong has been the attractive valuations compared with developed market equities. Compared with other regions, EM equities are not stretched and are currently trading at a 32% discount on a price-to-earnings basis. In addition, return-on-equity – which has long been an area of weakness – has started to turn higher and is nearing its long-term average. Both the cheaper valuations and improvement in the efficiency of companies’ asset bases have led investors to reallocate to EM. The increased flows also provide a boost to the performance of the asset class.
Macro Backdrop Supportive
The last piece of the puzzle has been the overall improvement in the macro environment for EM economies. EM assets tend to be a ‘long FX’ play, and Figure 3 shows the performance of the basket of EM currencies since 2000. Consistent with the deteriorating outlook, EM currencies have been on a downward trend since 2013 and have only recently started to stabilise. Compared with the long-term average, there is still room for currencies to rebound as commodities improve, which would be supportive for EM equities. Additionally, the weaker August jobs report in the US could provide for a more dovish Fed and, in turn, benefit emerging markets.