The most important questions for EM equities now
As investor interest in emerging market mounts, these are the top questions we ask…
- What are the upside and drivers for EM equities?
- Can EM equities still do well despite uncertainties in China?
- EM inflation and tightening a cause for concern?
- How might tapering affect EM equities?
- Other risks? Thoughts on the USD given that a stronger dollar tends to be negative for EM equities?
- Outlook for EM equities
1. What are the upside and drivers for EM equities?
After a blistering start to the year, the performance of EM equities (gauged by MSCI EM index) has tapered off, returning flat in the year-to-date. Looking ahead, we expect an upside of 23.0% by end-2023 (Chart 1, Table 1), driven by the combination of stable earnings growth and valuations re-rating.
Valuations for EMs, in terms of the forward PE ratio, is currently trading at 13.6X (’21 EPS estimates) and 12.3X (’22 EPS estimates), reverting back to the long-term average of 12.4X. More importantly, EM equities are trading at a wide 32% discount to DMs, dramatically above the long-term average of a 20% (Chart 2). From both absolute and relative valuations, we see a reasonable scope for re-rating and potential drivers down the road.
First, we see a wave of EM re-openings next year. Major EM countries have seen a surge in vaccination rates and Covid cases have steadily subsided. A wave of re-openings and international travel should revitalise macro data and regional risk appetite, uplifting EM equities. Second, we also see a shift back to cyclical and pro-inflation exposures. With higher inflation readings, rising yields, and improving US macro data, we are seeing a rotation back to cyclical and pro-inflation assets such as EM equities. Third, a positive shift in stance for China authorities can also drive EM equities higher. With bad news regarding moderating growth and regulatory headwinds firmly baked in China assets, we think a shift in stance – such as a softening of regulation intensity, growth stimulus or positive guidance – can spur re-rating in Chinese equities, thereby supporting EM equities.
Separately, we also see additional country/region-specific drivers, with most concentrated in EMEA and Asian markets. For EMEA markets, these are sustained elevated energy prices and positive earnings revision. For Asia, these are the opening up of international travel and the region’s relatively more accommodative central banks.
Chart 1: MSCI EM Index price and forecasted EPS
Table 1: Projections and potential upside for MSCI EM index
|EM (MSCI EM Index)||FY2020||FY2021||FY2022||FY2023|
|PE ratio (X)||19.9||13.6||12.3||11.2|
|Projected earnings growth (YoY %)||-15.6%||46.9%||11.0%||10.0%|
|Projected Earnings Per Share (EPS)||64.8||95.2||105.7||116.2|
|Target fair price (Based on 13.5X Fair PE ratio)||–||–||–||1,569|
|Potential upside (%)||–||–||–||23.0%|
|Source: Bloomberg Finance L.P., iFAST estimates. Data as of 28 Oct 2021.|
Chart 2: EM trading at an extreme discount to DM equities
2. Can EM equities still do well despite uncertainties in China?
China equities are a major component of the EM universe. Not only do they have the biggest exposure within MSCI EM index (around 35 – 40%), but many EMs also have a close economic dependency on China. Thus, weakness in China equities can reverberate across the EM universe. That being said, it is not to say that EM ex-China equities will necessarily suffer during a period of China weakness.
A look at earnings estimates for major EM equities show that, aside from China, most EMs have experienced rather significant positive revisions (Charts 3 and 4). Zooming closer in, those with the largest earnings revision are Asian markets, suggesting that headwinds in China are localised and have not contaminated earnings of EM peers.
Moreover, the earnings picture for EMs, on aggregate, remain relatively robust despite China’s recent woes. We expect a significant EPS rebound of 47% in 2021 for EM equities, on the back of cyclical tailwinds like rising commodity prices and global growth recovery. Earnings are likely to normalise in 2022 to 10%, but still in line with long-term average, as these cyclical tailwinds fade and base effects kick in.
According to Goldman Sachs Research, global mutual funds’ underweight allocations in EM ex-China equities are now near a decade low. From a contrarian perspective, this implies significant upside potential for EM ex-China equities if the underweight allocation is pared. A rotation back to cyclical and pro-inflationary positioning could be a likely trigger.
All in all, EM ex-China has largely held up well during the past year, especially concerning equity fundamentals. In conjunction with our view that the current woes in China are unlikely to be long-term, we believe investors should not be deterred from investing in EMs.
Chart 3: Despite negative revision in China, most major EMs saw positive revisions YTD
Chart 4: Earnings for EM ex-China were revised upwards by around 30% YTD
3. EM inflation and tightening a cause for concern?
The mix of rising energy and food prices, weaker EM currencies, and supply-side disruptions have resulted in soaring headline inflation in EMs. Higher food prices are a headache for EMs as these are typically more volatile, and hold an outsized weight in EM’s CPI basket – averaging 25% of the CPI basket for EMs and 15% for DMs. With the expectation that food and energy prices will remain high through ’21 and 1H ’22, we believe EM inflation may remain above average in the near-term. This will pose as a headwind for broad EM equities, however, some EMs remain more vulnerable.
We see greater inflation risks in LATAM followed by EMEA and Asia. This is primarily due to LATAM’s higher sensitivity to changes in food prices as well as a larger currency devaluation. Headline inflation for major economies of the region (Brazil, Mexico, and Peru) have exceeded the respective upper bounds of inflation target by a wide margin (Table 2), setting up for more potential rate hikes. We believe the region’s upside risk in inflation can potentially trigger macro risks such as an increased exposure to a reversal in capital flows and further rate hikes. These risks may have the potential to hold back LATAM’s growth momentum as well as re-rating for the region’s equities.
Table 2: Many LATAM economies have exceeded inflation targets. Asia and EMEA economies are in a better position
4. How will tapering affect EM equities?
Tapering has not been kind to EMs assets based on history. Back in May 2013, when the Fed first brought up asset tapering, EM currencies (as gauged by the JPM EMFX index) fell around 10% over a four-month period while EM equities fell by almost 20% (in USD terms) over the next two months (Charts 5 and 6). Looking ahead, it is possible to see negative reactions from EM equities this time, however, we opine that the impact is unlikely to be as violent and prolonged compared to 2013.
EM currencies are in a better position this time and are less susceptible to a 2013-style devaluation. First, many EM central banks have attempted to front-run inflation by raising interest rates over the past six months. This has pushed real rates (nominal rates minus inflation) higher, supporting EM-US real rate differentials (higher real rate differential in favour of US drives the USD higher and weakens EM FX) and creating a buffer for EM currency strength. Second, most EMs’ currency reserves and current account balances have improved and are healthier when compared to 2013. As such, EM currencies are less prone to sharp outflows as many EMs have become less dependent on foreign flow and cheap USD liquidity. EM central banks also have more ammo to fight large devaluation.
EM equities are less vulnerable as current equity positioning is much lesser now as compared to 2013. Prior to the announcement of 2013’s taper, EM equities rallied in 2012 on the back of strong growth that outpaced DMs significantly. As such, EM equities saw stable portfolio inflows which resulted in heavy-handed positions going into the 2013’s taper tantrum. On the contrary, recent slew of negatives from EMs have resulted in sharp outflows over the past 5 months. The contrast in positioning, therefore, implies that a potential taper-induced risk-off may be milder in magnitude and duration this time.
Chart 5: EM equities were hit hard during taper talks (May) and after the start of tapering (Dec) in 2013…
Chart 6: …The same was observed for EM currencies
5. Other risks? Thoughts on the USD given that a stronger dollar tends to be negative for EM equities?
Covid-19 remains a key headwind but with the recent delta-variant cases subsiding, the spotlight has turned to vaccination rates in major EMs. Consequently, many EM assets have re-priced to reflect a rosier economic prospect based on higher inoculation rates. Therefore, aside from the virus risk, we view a potential disappointment in inoculation rates as a risk to watch.
A hawkish tilt by the Fed has put upwards pressure on the USD since June 2021. However, we think markets have been rather optimistic and have front run the hawkish narrative. USD positioning (in terms of futures contracts) rose dramatically after the recent FOMC meeting (Chart 7), suggesting that market participants are betting for an earlier taper. Therefore, given the current bullish USD positioning, we expect limited upside if USD strengthens. Further, we note that two major drivers of the USD – sustained higher US real rates and strong US economic outperformance – are absent this time and thus, may also limit the upside for USD.
Chart 7: Net long position in the USD is seemingly peaking as market have front run the hawkish Fed narrative
6. Outlook for EM equities
Beneath the hood, EM equities remain supported by robust earnings fundamentals with clear equity drivers such as i) a shift towards cyclical and pro-inflationary positioning, ii) international travel and re-openings in 2022, and iii) a positive shift in China policies. There is also potential for catch-up to DM equities, as EM equities’ relative earnings outlook have improved but they are still trading at a wide discount to the former.
Based on these parameters, we remain broadly positive on EM equities. However, we note that there are more headwinds on the horizon (as outlined in this article) and therefore may i) introduce volatilities in the near-term and ii) drive diverging performances across regions and countries, as markets digest the impacts.