Earnings growth, cheaper valuations put emerging-market equities back in favour
ONE OF the most notable effects of the political change that has taken place in South Africa since December has been the recovery in investor sentiment. There has been a notable rise in foreign interest on the JSE.
This is not only because of greater optimism about the country’s economy, but also because there is a very positive view towards emerging markets in general. In fact, until December, South Africa had been left behind by an emerging-market rally that began in 2016. Local political uncertainty had caused foreign investors to be net sellers of South African equities, even while they were buying up stocks in markets, such as India and Russia, that were performing strongly.
This out-performance in emergingmarket equities is typical of a latecycle bull market. Since March 2009, the Standard & Poor’s 500 Index has not suffered a drop of 20% or more, making this the second-longest bull market in history.
“Over the past few years, we’ve spent a lot of time on the big developed markets, but it’s now late in the cycle and markets such as the US and Europe are starting to show a lot less value,” says Brian McMillan of Investec structured products. “Emerging markets are looking far more attractive.”
This was certainly true in 2017. Last year, the MSCI Emerging Markets Index was up 37.28% in US dollars, compared with the 22.40% growth in the MSCI World Index. This was the strongest annual performance by emerging markets since 2009.
“Investec’s research outlook is for this out-performance to continue,” McMillan says. “Valuations remain cheap compared with developed markets, and the global economic environment is very supportive.”
The International Monetary Fund has raised its global economic growth forecasts for 2018 and 2019 from 3.7% to 3.9%. This is encouraging for emerging markets, as an analysis by Investec shows that, from 1996 to 2017, earnings growth for companies in emerging markets has averaged 19% in years when global growth has been above 3.5%.
Higher global growth is also typically supportive of commodity prices, and Investec has found that, over the same period, emerging-market equities have never underperformed developed-market equities in a year in which commodity prices have gone up.
However, the one commodity that is unlikely to rise too steeply is oil. This is again positive for emerging markets, and global growth more generally.
In a recent investment note, Franklin Templeton investments argued that emerging markets are now more resilient than they have been in the past.
“There may be volatility ahead, but many emerging markets have stronger reserve positions and lower external debt today than historically, which makes them less vulnerable to external shocks,” Franklin Templeton noted. “Moreover, emerging countries each have their own idiosyncratic domestic drivers and hence are less correlated to one another and the global market as a whole.” This all points to an exciting outlook for emerging-market stocks. However, many local investors feel that, because South Africa is an emerging market, they already have adequate exposure to this theme.
Edwin Smit, a portfolio manager at BVG Financial, argues that this is not necessarily the case.
“South Africa is a bit more expensive than most emerging markets at the moment,” he says. “So even though we do expect some upside for local commodities, it’s also wise to get exposure to other markets.”
China and India may be the most obvious growth stories, but he believes there are also opportunities in other countries, including Malaysia, Indonesia, Brazil and Poland.
“Diversification is always important in any portfolio,” Smit says. “Even if you are in an emerging market like South Africa, you should think about getting exposure to different markets, such as Poland, which is not very well endowed with natural resources but is still an emerging market and so has different growth drivers.”
For South African investors, however, it has not always been easy to get exposure to these regions.
“A lack of access is probably one of the biggest reasons local investors are generally underweight on emerging markets,” says McMillan. “How do they get exposure to markets such as China or Brazil?”
The growth in index-tracking products in recent years has provided a potential solution, as a broad emerging-markets index offers investors exposure without the need to pick specific regions or stocks. Structured products built on these indices are also growing more popular, given the risk protection that they offer.
“One of the problems with investing late in the cycle is you’re not sure how much longer the cycle will continue, or whether you may be too late,” McMillan says. “However, a structured product that offers some capital protection gives investors the confidence to diversify into emerging markets with some comfort that they have reduced their downside risk.”