Cheap valuations and attractive dividend yields are two of the four elements of a ‘quadruple whammy’ that could help reverse the slump in emerging market stocks, according to River & Mercantile’s Al Bryant.
Higher US interest rates, the trade tensions between the US and China, rising oil prices and growing fears of global economic slowdown combined to put a significant dent in investor sentiment towards emerging market equities.
FE Analytics shows the MSCI Emerging Markets index made a 9.27 per cent loss (in sterling terms) over the course of 2018, compared with a fall of just 3.04 per cent from the developed markets-focused MSCI World.
Performance of indices during 2018
Source: FE Analytics
Al Bryant, who joined River & Mercantile in 2017 from Credit Suisse with the Industrial Life Cycle (ILC) team that he heads up, said: “There have been a lot of headwinds for emerging markets in the last 12 months, but the primary one was the strong economic growth of the US and the corollary normalisation of interest rates.
“This caused losses to mount for emerging market equities; a good portion was based on emerging market FX declines against the rising dollar.”
However, this year has started with much stronger conditions for emerging markets. Over 2019-to-date, the MSCI Emerging Markets index has risen by 6.02 per cent in a global rally; the MSCI World has made 8.04 per cent in this period.
Bryant thinks these positive conditions could potentially be in place for some time, as four key drivers – cheap equity valuations, attractive dividend yields, “beaten down” currencies and improving profitability – combine to bolster sentiment towards the asset class.
“A large cross-section of emerging market companies have improved balance-sheets and have been showing an improvement in profit margins,” he said.
“Dividend yields also now average 3 per cent for emerging market stocks which has been a decent historical signal for subsequent gains.
“Of course, the risk with emerging markets is always that stocks are cheap for a reason, but in the absence of further global turmoil, these positive factors could be very powerful for emerging markets.”
Performance of indices during 2019 to date
Source: FE Analytics
Looking at these for factors in more detail, Bryant cited data from consultancy Yardeni Research on how emerging market shares look relatively inexpensive at present when compared with large parts of the developed world.
With a forward P/E (price-to-earnings ratio) of 11, emerging markets are “considerably cheaper” than the US’s 15.4 as well as being less expensive than the UK’s 11.7, Japan’s 11.7 and the EU’s 11.8.
Meanwhile, MSCI data shows that emerging markets currently offer a dividend yield of 2.91 per cent. The manager noted that this is the same as the 2.91 per cent yield on offer in the UK and “much higher” than the 2.09 per cent that investors can pick up in the US index.
When it comes to currency, the JP Morgan Emerging Market Currency index is down 28 per cent against the US dollar from medium-term highs in the summer of 2014. It is also down 11 per cent from most recent highs in early 2018.
Finally, improving profitability in emerging markets could prove attractive to investors. The MSCI Emerging Market index’s return on equity rose to 13 per cent in 2018, up from lows of 10.7 per cent in 2015; analysts expect this improvement will be maintained in 2019.
Chetan Sehgal, lead portfolio manager of Templeton Emerging Markets Investment Trust, is another investor taking confidence from the strong start to 2019 and expecting it to continue over the coming year.
He explained: “We believe that confidence in emerging markets could strengthen further based on several factors: economic growth differentials between emerging markets and developed markets are widening in the former’s favour, emerging market currencies appear undervalued despite balance of payment surpluses in many markets, ongoing reforms, a robust emerging market earnings outlook and undemanding valuations.”
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
Sehgal, who has run the £1.9bn trust since the start of 2018, added that he is “particularly upbeat” about growth prospects in the information technology and consumer-related sectors against this backdrop of attractive long-term valuations.
“The growing adoption of technology and growth of digital platforms have helped create new goods and services for consumers across emerging markets, and at the same time creating growth opportunities for many emerging market companies and investors,” he said.
“Additionally, with most young people – those under the age of 30 – in the world living in emerging markets, we believe there are tremendous opportunities for businesses that can effectively capture and serve this target market.”