Can the EM recovery continue?

Can the EM recovery continue?

Since 2011, emerging market (EM) equities have underperformed developed market (DM) equities significantly. However, history shows that performance leadership tends to rotate over multi-year periods. Following a four-year period of weakness, we are cautiously optimistic that the recovery in EM equities seen so far in 2016 could be sustained.

Relative EM valuations are now attractive on almost any measure. Helped by the recovery in oil prices, EM economies are stabilising and expectations of US monetary policy normalisation have been pared back. In addition, global yields which are already at unprecedented lows keep going even lower, continuing to push investors into higher-risk assets.

At a glance

EM equities’ four-year period of underperformance has been reversing in recent months

The outlook for EM equity is supported by:

 Attractive relative valuations
 Stabilising EM economies
 The recovery in oil prices
 The paring back of US rate hike expectations
 Unprecedented ultra-low global yields

However, these supportive factors are all challengeable and given EM equities’ higher risk level a selective approach is key

EM equities’ extended run of underperformance

Chart 1 below shows the episodic nature of EM and DM equity performance. In particular, multi-year periods of EM underperformance tend to be followed by multi-year periods of EM outperformance.1 Since 2011, EM equities have produced a total return of minus 11%, a substantial underperformance compared to DM equities (as represented by MSCI World Index), which returned +56% and US equities, which returned +95%.2

Chart 1: Significant EM underperformance since 2011

Source: Datastream, August 2016

The Chart above suggests that global macro conditions are linked to the ascendancy of either DM or EM and that identifying those moments when performance cycles turn can be profitable for investors. Following a four-year period of underperformance, a turnaround has been in evidence in recent months, with EM equities outperforming DM by 7% since March. We look at the factors that could sustain the recent EM recovery.

Attractive relative valuations

A consequence of EM equities’ sustained period of underperformance is reduced valuations compared to DM equities. Chart 2 below shows that EM equities’ current price/book ratio of 1.5 is below the 20-year average of 1.8 and offers a 28% discount to DM equities. Chart 3 shows that EMs’ one-year forward price/earnings ratio of 12.3x is also lower than the DM ratio of 15.7x.

If we normalise earnings over the past 10 years, then the picture remains broadly similar, with EMs’ ‘Shiller PE’ ratio of 11.1x around 20% below the DMs’ Shiller PE of 13.3x and far below leading individual country DM Shiller PEs, such as US large cap (26x) and Japan (20x).3

Chart 2: EM at price/book discount vs. DM

Source: Datastream, August 2016

Chart 3: EM at price/12-mth forward earnings discount vs. DM

Source: Datastream, August 2016

Stabilising economic growth

Lower valuations are often indicative of weaker economic fundamentals which are typically associated with a weaker outlook for profits. As a whole, it is true that EM economies have been slowing in the past few years, owing to the related factors of slowing growth in China, weak commodity prices and disappointing export growth. However, in most cases EM economic growth appears to have stabilised. Aside from the Chinese economy, which is responding to further monetary and fiscal easing, high frequency indicators for Russia and Brazil have picked up recently. In line with this, EM returns on equity have picked up since April and are now very slightly higher than for DM equities,4 having lagged DM returns since mid-2014 as shown in Chart 4 below.

Chart 4: EM ROEs no longer lagging DM

Source: Datastream, August 2016

EMs’ earnings return potential should be seen in the context of some of the well-known structural factors underpinning EMs’ longer-term economic growth outlook. For example, it is well established that the consumption potential of EM countries such as China will increase rapidly on the back of wage growth, urbanisation and increased financial intermediation.

For investors wishing to gain exposure to long-term EM themes, the current relative valuation discount could suggest an attractive entry point. However, a major limitation in this regard is that a number of the stocks most directly exposed to such themes (in areas such as the internet, healthcare and consumer sectors) already appear richly priced. This is something that underscores the need for selectivity and a long term approach. Careful stock-level analysis is required to ensure that risk is controlled and that growth is not over-priced. If a company has a growth profile that drives a consistent increase in value over time, the precise entry point may not be so critical owing to the earnings power of the business compensating investors sufficiently over the longer term.

“Interest and flows in to EM equities have been picking up. Currencies have stabilised and investors can now go for the carry trade again. A caveat is that while overall valuations are cheap, there is polarisation in most markets between expensive new economy stocks and cheap old economy/banking stocks. This further underscores the need for an active approach in an asset class that remains under-researched relative to developed markets yet subject to greater corporate governance and political risks.”


Richard Lewis Head of Global Equities


Recovery in oil prices

Many EM economies are heavily reliant on commodities. Chart 5 below shows a relatively high historical correlation between EM equity returns and commodity prices. This is particularly the case for the oil price which has a 20-year correlation to the MSCI EM index of 0.66. Given this, the recent recovery in oil is important. Brent crude hit a closing low of USD27.92 per barrel on 20 January but has since rebounded by over 50% to about USD45.

Consistent with the positive correlation, EM equities are up by over 28% since this date, outperforming DM equities by more than 12 percentage points over the same period.

Chart 5: Relatively high correlation with commodities

Source: Datastream, August 2016

Expectations of US monetary normalisation pared back

EM equities are widely seen as among the biggest beneficiaries of the unprecedented loosening of monetary policy globally, including quantitative easing. Unsurprisingly, in the past few years they have been hugely sensitive to any signs of policy tightening, particularly from the US Federal Reserve.

However, the US Fed has consistently surprised the market by normalising its monetary policy more slowly than expected, even compared to its own forecasts. When the much-feared first US rate hike finally arrived in December 2015, EM equites and EM assets in general responded with impressive equanimity, with the MSCI EM index having risen by 12% since. This resilience probably reflects the significant paring back of US rate rise expectations over this time period. Only one further rate rise is now expected in the whole of 2016, and expectations for the long term ‘terminal’ Fed funds rate have been reduced to 3.0%.5 This has taken place together with further policy easing from the world’s three other major economic players, Europe, Japan and China.

Chart 6: On average, EMs outperform after the first US rate hike

Source: Fidelity International, Datastream, August 2016

Fears of a negative impact on EM assets of US rate hikes may in any case be exaggerated. Chart 6 above shows that the one-year EM equity total return after the first US rate hike, averaged for the previous four US rate cycles, was 15%, with an average two-year return of 35%. EM equities’ 11% return since the December 2015 Fed hike is therefore in line with the historical pattern. US rates hikes typically occur when the US economy is doing well and contributing positively to global economic growth. A period of very gradual Fed hiking in an environment of solid US economic growth and very low US inflation, could be a favourable rather than an alarming backdrop for EM equities.

The unprecedented ultra-low global yield context

Arguably the most remarkable global development of 2016 to date has been the continued decline in global bond yields. Some 36% of all sovereign bond yields are now offering negative yields with only 6% offering yields above 2%.6

Chart 7: The rise of negative yields in DM bond universe

Source: Bloomberg, UBS, as of July 2016

This matters greatly for all asset classes, including EM equities, because the decline in yields of perceived safe-haven country government bonds is functionally similar to a decline in the global risk free rate, which rationally makes holding riskier and higher yielding assets more attractive on a relative basis.

“Since the UK’s vote to leave the European Union, the search for yield and good returns has become an even greater area of focus for investors. Lower for longer is an enduring theme, as bond yields continue to decline. Whilst I believe higher return businesses remain underappreciated by the market, there is an increasing acknowledgment that within emerging markets there are many opportunities to secure solid, attractive returns amid increasing investor appetite for riskier assets.”


Nick Price Portfolio Manager, EM Equities


Some important caveats

All of the supportive factors just outlined can be challenged and any investor in EM will need to tread carefully. Improvement in economic indicators may not last if the impact of Chinese policy stimulus fades and if this leads to a renewed decline in demand for commodities, prices for which are positively correlated with EM markets as shown. Moreover, US growth and inflation data could surprise on the upside, leading to an upward re-calibration of market expectations for US rate hikes. Despite evidence showing EM equities can perform well in US rate rising periods, this would almost certainly lead to some short term volatility.

Beyond this, there is also the unavoidable reality that EM equities are higher-risk assets and prone to higher volatility, and so deserving of a valuation discount to DM counterparts. Higher EM equity risk/volatility can be attributed to a wide range of structural factors, including significantly higher political risk (as recent events in Turkey have reminded), weaker corporate governance standards and increased government involvement and interference in the private sector. Higher government involvement in the EM private sector can be a particular concern, because such companies invariably have considerably lower ROEs compared to their fully private counterparts, owing to political rather than shareholder-friendly decision making.


EM equities’ four-year period of underperformance versus DM equities has been reversing in recent months. We outlined the case for the recent EM recovery being sustained on the basis of attractive relative valuations, stabilising EM economies and the recovery of the oil price, which we showed is correlated to EM equities. In addition, the EM equity case is also supported by easing US rate hike expectations at the same time that the global risk free rate effectively continues to fall due to increasingly negative yields on perceived ultra-low risk assets.

However, any asset class level optimism needs to be measured since almost all of the supportive factors outlined can be challenged. In addition, EM assets are more volatile due to issues such as higher political risk and lower corporate governance standards. Considering also the fact that many of the most attractive structural EM stock plays appear richly valued, this very much re-enforces the need for a selective and risk-controlled approach to EM equities.


1) All references to EM equities throughout refer to the MSCI EM Index (USD)

2) US equities represented by S&P 500 Index

3) Research Affiliates, August 2016; DM proxy referred to here is MSCI EAFE Index

4) End-July MSCI EM ROE was 10.43% while, the MSCI World ROE was 10.35% (datastream)

5) One further rate rise expectation in 2016 was as of 11 August 2016. The ‘terminal’ Federal Funds rate is where the current rate hiking cycle is expected to be concluded over the ‘longer run’, as depicted in the US Federal Reserve’s ‘Dot Plot’ figure, in the latest Summary of Economic Projections, 16 June 2015

6) 'Markets confound in year's first half',, 2 July 2016

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