Recent trends in macroeconomic data for emerging markets highlight that current account deficits are slowly improving and many investors regard the recent mini stimulus package announced by China as a positive step. Indeed recent fund flows data suggests improving sentiment towards the emerging markets. Of course there are still headwinds; investors are still voicing concerns over Chinese credit, margin pressure and persistent commodity price weakness.
At AXA Rosenberg, we do not make macro asset allocation calls, but we do continually assess and monitor fundamentals. When we look at the underperformance of emerging markets and compare it with underlying earnings, relative to developed markets, we notice a disconnection that has never been as large as it is today.
Performance of indices since Oct 2010
Source: FE Analytics
Since October 2010, emerging markets have underperformed developed – as measured by MSCI global indices – by [49.63] percentage points [according to FE data], but over the same period emerging-market earnings have only lagged developed markets by 14 per cent, as shown in the chart below.
Price and earnings relative of EM and DM since Oct 2010
Source: AXA IM
Historically, when emerging markets have been out of favour as an asset class, equity-index underperformance has been accompanied by a similarly large drawdown in relative earnings.
For example during the Asian currency crisis and the Russia crisis of the late 1990s, emerging markets underperformed developed markets by 58 percentage points, but their relative earnings also declined by 51 per cent. This is measured over the period Feb 97-Feb 99.
One reasonable explanation for the current decoupling of prices from actual delivered earnings is that investors have become much more pessimistic about the long-term earnings potential in emerging markets.
However this is not reflected in bottom-up IBES forecasts for 2014-16, where expected annualised earnings growth is currently 10.9 per cent – in line with its long-term trend.
So, looking purely at the numbers the level of underperformance of emerging markets relative to developed since late 2010 is hard to justify given the evolution of actual earnings.
Where does all this leave emerging-market valuations? In the table below, we show the 12-month forward P/E [price-to-earnings] ratio for major developed markets compared to that for emerging markets.
Currently global emerging markets trade on just 10.7 times, which is a 28 per cent discount to global developed markets. If one also factors in the aforementioned expected earnings growth for 2014-16, then emerging markets trade on a growth-adjusted P/E (PEG) that is below 1, compared to 1.37 for development markets.
Source: AXA IM
So in summary, while we at AXA Rosenberg do not make asset-allocation recommendations, the fundamental data we observe indicates that emerging market equities are available at very attractive levels, both in absolute terms and relative to developed markets.
The unprecedented decoupling from developed markets that we have noted is not underpinned by an earnings collapse, and as such the prospect of a rerating from here looks feasible given the macroeconomic improvements that are already underway.
Jonathan White is the deputy head of client portfolio management at AXA Rosenberg. The views expressed here are his own.
