Over the past 12 months, there have been similarities in the drivers of large-cap and small-cap emerging markets stocks. Investors in both universes have strongly favoured stocks with strong earnings momentum, return on equity, and historical earnings growth characteristics. 
However, there seems to be little appetite in both segments for stocks with strong forecast earnings growth. From a valuation standpoint, relatively cheap stocks have tended to lag when looking at a variety of metrics such as price-to-book and earnings yield.
In the current less certain economic environment, investors have been pursuing safer investments whether that means traditional safe harbours (healthcare and telecom services) or stocks that offer sustainable earnings growth. They have also been looking towards markets less prone to currency volatility.
Performance of indices over 3yrs
Source: FE Analytics
Therefore, we think it is important for the macroeconomic context to stabilise in order for us to see renewed interest in emerging markets. We believe that moderate global and local economic growth, moderate inflation, and a moderate interest rate environment, all in the 2-3 per cent range, will provide the backdrop for more emerging markets companies to restore the health of their balance sheets and deliver better-quality growth, which would help multiples expand.
The US Federal Reserve has telegraphed its rate hike intentions for several years now and recent analyst polls suggest that the first increase could occur as early as this September and as late as next year. Even though we believe these expectations are largely priced into emerging markets equities, largely through movements in foreign exchange markets, we do not rule out the potential for market turbulence after the Fed’s initial hike.
Although there are concerns that rising borrowing costs will dampen growth in the emerging world, we think higher rates could help restore capital discipline among companies where it has been missing, as lax capital management has been abetted by years of easy money.
This has been one of the reasons for weaker profits in developing markets, which have declined to levels comparable to those in the developed world. If tighter credit conditions begin to put pressure on weak managements and bring out the skill of strong ones, we believe this could encourage the market to differentiate more strongly between companies. For this to happen, however, we believe US rate hikes must be carried out gradually and in small increments to avoid shocking the market.
It is not news that China’s economic growth is slowing—this downdraft began in 2007, when growth peaked at about 14 per cent. And many economists and investors continue to question the official GDP growth figures.
However, regardless of what the actual growth rate is, the more important issue to us is how this slowdown is managed. It appears that China, possibly in observing the recoveries in Europe and the United States, has decided that stimulus is appropriate for its own economy. In June, Beijing made two significant decisions: 1) bank reserve ratios have been lowered; and 2) the benchmark lending rate has been cut.
While this was a small first step, China has more levers to pull to meet its 7 per cent growth target for 2015, including reform by state-owned enterprises (SOEs), the launch of the Shenzhen–Hong Kong trading conduit, and the launch of QDII2.
Chinese SOEs are revealing that they will for the first time have their performance evaluated on their ability to manage profitability. This is a significant shift in management culture as Chinese companies have historically been more growth-oriented than profit-oriented, and concerns that reforms have not yet translated to earnings-per-share growth could ease.
China’s efforts to promote a wealth effect through local participation in the stock market do not appear to be yielding the intended consequences. Chinese onshore equities, also known as A-share stocks, abruptly transitioned from a boom period to a volatile decline that has extended into July as of this writing.
Central authorities rapidly unleashed a barrage of policy changes in June to prop up its onshore stock markets. These included a new ability for pension funds to invest in local equities. China’s $560 billion government pension fund is now permitted to invest up to 30 per cent in local equities. At an early glance, this appears to be a positive development as institutional participation should boost the market’s liquidity and stability.
The recent volatility in Chinese equities has largely been limited to stocks on two of China’s three stock exchanges. This is an important distinction as they attract different types of company listings and, thus, different types of investors.
Performance of indices over 2015
Source: FE Analytics
The rout has been most pronounced in the mainland-based, retail-driven, Shanghai and Shenzhen indices, which generally consist of smaller-cap companies listed as A-shares (renminbi-based) and B-shares (foreign currency-based). Meanwhile, the Hong Kong–based exchange has been significantly less volatile given its institutional investor base. Its listings primarily consist of blue-chip Chinese companies floated as H-shares.
The A-share volatility occurred after China’s securities regulator eased restrictions on cross-border trading last November. Trading on the mainland exchanges was previously restricted to China’s mainland residents, who were simultaneously barred from investment in Hong Kong–listed Chinese stocks. This changed with the Hong Kong–Shanghai Stock Connect programme, which broadened access to A-share and H-share stocks for foreign and local investors, within preset daily trading volume limits. The retail-fuelled boom in the A-share market began late last year, and spilled over into the H-share market in March. Our analysis suggests that much of this recent activity in A-shares and certain H-shares is not fundamentally driven.
While we don’t disagree with China’s economic policies, and welcome the institutional presence granted by pension investments, we continue to look for the evolution of China’s economy and markets to be driven less by state-directed investment and more by the private sector. The backdrop is also unorthodox as local stock investments are being encouraged as part of a national rallying cry to build household wealth.
What do we make of this? In the near term, we think this is noise. Longer term, this market segment could take on more significance to us, especially if China A-shares are added to MSCI’s widely tracked Emerging Markets Index. By MSCI’s estimate, this could happen in small increments by May 2017 and possibly even earlier. While, we currently have no A-share holdings in our portfolios, we do have broad exposure to almost all sectors of the economy, in companies where we believe the outlook for earnings growth and profitability still looks healthy.
Emerging markets equities were trading at a 10 per cent forward price-to-earnings discount to their historical average as of 30 June and a 28 per cent discount to developed markets. Although the discounts rightly reflect the structural problems in emerging markets, it also suggests that a value opportunity may be at hand considering that meaningful reform efforts are underway in many developing countries.
Across most markets, we are still finding a select group of companies that are not just navigating the environment well, but also profiting from it by taking market share from weakened competitors. Over time, as economies globally and locally recover, there should be more widespread recoveries for a broader universe of emerging markets companies.
Shorter term, tighter emerging markets credit conditions from US rate hikes could force better capital discipline among companies, which should translate into improved profitability and allow for multiple expansion.
Paul Rogers is the manager of the Lazard Emerging Markets Core Equity fund. The views expressed above are his own and should not be taken as investment advice.