Not just a bounce: The cyclical case for emerging markets

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This is a sponsored article from Goldman Sachs Asset Management.
 

Introduction

  • The performance of Emerging Markets (EM) and Developed Markets (DM) has been characterised by sustained periods of out and underperformance over the last 30 years, coinciding with shifts in the relative pace of EM vs DM economic growth.
  • In line with this, we believe that the EM vs DM strength we have seen since January 2016 represents the early innings of a new multi-year period of outperformance1.

EM market outlook
Our constructive outlook for EM is underpinned by three primary factors:

  • Economic growth: macro fundamentals continue to improve, investment momentum is picking up and monetary policy remains broadly accommodative
  • Earnings: margins are re-accelerating, Earnings Per Share (EPS) is surprising to the upside
  • Valuations: valuation multiples continue to look reasonable despite the recent strong performance and yields continue to look attractive, especially relative to those available in DM

We believe selectivity within EM is crucial, as country, sector and stock-specific forces drive each asset class, making a single, broad view inappropriate.

Macro: momentum is picking up, monetary policy remains broadly accommodative
Through our engagement with companies across EM over 2017, we found many were beginning to see an improvement in their underlying operating environment.

Relative to 2013, when EM suffered through the taper tantrum, many EM countries have taken strides to reduce their significant external imbalances, resulting in improved current account positions, considerably lower inflation relative to recent history, and re-accelerating GDP growth.

The differential in real GDP growth between emerging and developed markets narrowed from ~7.5% at its 2009 peak to ~2.5% in 2015 as Chinese growth moderated and the commodity rally, which spanned most of the last decade, lost steam. A synchronised recovery in GDP growth across the EM universe since 2016 has arrested this trend and IMF forecasts point to a continued widening of this spread over the coming five years.
 

Spread of real GDP growth between EM vs DM expected to widen
A rebound in momentum has historically correlated with a period of multi-year outperformance of EM equities vs DM as the improved growth outlook supports higher earnings growth2

Source: IMF World Economic Outlook database, GSAM. Data as of Q4 2016.


Earnings: margins are re-accelerating, EPS is surprising positively

The supportive macro environment highlighted above is beginning to feed through into EM earnings, which are coming off a low base. 2017 marked the first year of double-digit earnings growth in seven years, as well as being the first time EM earnings have positively surprised to the upside, relative to consensus expectations at the start of the year, since 2011. As the EM capex cycle — which has been at cyclical lows — continues to recover, we would expect to see further improvements in operating leverage, which, coupled with declining funding costs, should support growth3.

2017 marked the first year of double-digit EM earnings growth in seven years with a positive surprise to the upside
MSCI EM annual earnings picture (Consensus EPS growth revisions in USD)

Source: Goldman Sachs Global Investment Research.


Valuations: multiples and yields remain attractive

Over the course of 2017, EM equities returned +37%, outperforming DM equities by approximately 15% (all returns in USD). EM debt returned 10% (JPM EMBI GD Index). This marked the strongest year for EM absolute and relative performance in the past seven years. The majority of this return has been derived from an improved earnings backdrop for EM corporates and improved fundamentals for a range of sovereign issuers.

This improving backdrop, as well as incremental concerns from some investors around valuations and low yields in certain developed markets, has resulted in an increased flow of capital into EM assets. However, despite this pick up in appetite and improved performance more recently, it is important that investors do not lose sight of the fact that EM equities have still lagged developed markets by more than 50% over the last five years.

EM valuations have increased since the lows of 2011 and 2012. However, even with the recent rally, multiples still only sit at around the long-term average level and, relative to developed markets, nominal and real yields remain attractive. Given the backdrop for continued economic growth, and earnings revision and returns that we have described above, we see this as an attractive entry point into the asset class. This is particularly true relative to certain parts of the developed world which trade at a meaningfully more elevated level.

Despite the recent rally, EM valuations remain close to long-term average levels while relative to developed markets, yields look attractive
Valuations – forward price-to-earnings ratio

Source: GSAM, DataStream, Dec-17. Equity valuations shown for next twelve months price to earnings ratio for MSCI World and MSCI.

 
Over 2017, we saw sizeable capital flows into EM assets, with approximately $80bn going into EM equities and $110bn going into EM fixed income4. These were partly due to the sharp reversal in sentiment and flows that were observed in 4Q16 as the market reacted to the outcome of the US elections. This was coupled with the perceived risk of increased protectionism, rising rates and a stronger dollar. As these concerns failed to materialise to the extent feared, many investors have refocused on the improving macro and micro fundamentals across EM.

While the case for investing in emerging markets, to us, seems clear, the optimum investment strategy to access the growth potential may be less obvious. In an upcoming article5, we will explore what we see as the key facets of a successful approach to investing across the range of EM asset classes and discuss how to manage some of the inherent risks.

1 The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
2 Past correlations are not indicative of future correlations, which may vary.
3 The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
4 Source: EPFR data, JP Morgan.
5 Published in the May 2018 edition of Asian Private Banker

 

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This is a sponsored article from Goldman Sachs Asset Management.

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