Today’s CIO Weekly Perspectives comes from guest contributor Conrad Saldanha.
In last week’s CIO Weekly Perspectives, Erik Knutzen wrote about the importance of focusing on the business cycle when the markets are enduring a lot of volatility driven by the news cycle.
Nowhere is this truer, arguably, than in emerging markets, which often find themselves at the mercy of investor flows and sentiment. After rising some 15% since the end of December, the MSCI Emerging Markets Index has given about half of that back again in May, particularly as the tone in trade talks between the U.S. and China has grown darker.
In fact, we would expand Erik’s point. Understanding what is going on in emerging markets means not only contrasting the short-term news cycle with the business cycle, but also with the medium-term electoral cycle, and the long-term mega-cycle that the emerging world has been in since at least the late 1990s.
That mega-cycle has seen widespread integration of emerging markets into the global trading system, most notably with China entering the World Trade Organization in 2001.
Subsequently, there has been an evolution in the constituent industries of these countries, moving from commodity production and lower-value manufacturing to technology and services. This has not only increased the sophistication, the return on equity and the earnings growth prospects of emerging markets, but also increased their domestic focus and heterogeneity.
There has been broad adoption of orthodox economic and fiscal policies, including inflation targeting, by independent central banks, which has lowered inflation and compressed risk premia in government bond markets over time. A general move toward more local-currency and longer-term financing, a build-up of foreign-exchange reserves and more balanced current accounts have made sovereigns a more stable foundation for their domestic industries and corporations. Many countries still maintain positive real interest rates, giving them policy flexibility to stimulate if necessary with less pressure on their currencies.
The companies themselves increasingly compete against global peers and work with institutional investors—including ourselves—who actively engage to help improve disclosure and optimize capital allocation to the benefit of all shareholders. That has resulted in an increasing number making improvements not only in their operations, but also in corporate governance. Nonetheless, selectivity is key, given the heterogeneity.
In terms of the political cycle, we are now beginning to see the first generation of pro-reform administrations consolidate their positions or cede to similarly reformist leaders.
This is not the case everywhere. President Mauricio Macri is polling badly in Argentina with elections due later this year. Turkey is an example of how economic orthodoxy can slip as political dominance grows. These countries are more significant for emerging markets debt investors than equity investors, however.
The direction of travel is more positive in other countries, which, together, make up a meaningful proportion of emerging markets equity capitalization. Joko Widodo was declared the winner of a second term as president of Indonesia last week. Brazil is pressing on with much-needed economic reform under President Jair Bolsonaro and his finance minister Paulo Guedes. Perhaps most significantly, exit polls point to Narendra Modi winning a second term as prime minister in the ongoing elections in India. During Modi’s first term, India already implemented a national goods and services tax, while also improving its corporate bankruptcy laws. Both should boost the economy over time.
Again, it’s important to note that divergence across markets on this issue argues for an active approach to country allocation.
Turning to the business cycle, while the U.S. economy and equity market show signs of being late in that cycle, emerging markets generally appear still to be mid-cycle. The MSCI Emerging Markets Index price-to-earnings ratio of 12 times compares favorably with the S&P 500 Index ratio of 17 times and the MSCI World Index of global developed markets at 16 times. Moreover, as we have argued in the past, the growing technology component in emerging markets should imply slightly higher valuation multiples than in the past. In our view, current valuations are not late-cycle valuations.
Neither are emerging market fundamentals showing signs of late-cycle fatigue. Whereas corporate earnings have raced ahead of GDP growth in many developed economies, they still lag GDP growth in many emerging economies. India, one of the larger index constituents, is a notable example, where 2017 earnings shrank by 0.9% even as GDP grew by 6.7%.
Corporate leverage has been declining much more rapidly than it has among developed market companies, too: According to Bank of America Merrill Lynch Global Research and evidence from company reports, whereas both global emerging markets and U.S. companies’ net debt-to-EBITDA had risen to around 2.5 times by the end of 2015, since then U.S. corporate debt has plateaued, while in emerging markets it has declined to around 1.5 times. This helps to explain why the default rate surprised on the downside during 2018.
There is no doubt that uncertainty around trade policy, an uneven recovery in China and Europe, and the stubborn refusal of the U.S. dollar to reverse its year-long rally have all been weighing on investor sentiment recently. Should some of the heat die down in the U.S.-China dispute, however, we believe that would lend support for the incipient recovery in China and other emerging markets to solidify in the second half of 2019. Along with the recent dovish turn at the Federal Reserve, that can help to focus attention back onto the attractive, mid-cycle fundamentals and valuations evident across selective segments of the emerging equity market.
In Case You Missed It
- U.S. Existing Home Sales: -0.4% to SAAR of 5.19 million units in April
- Japan Purchasing Managers’ Index: -0.6 to 49.6 in May
- U.S. Purchasing Managers’ Index: -2.0 to 50.6 in May
- U.S. New Home Sales: -6.9% to SAAR of 673,000 units in April
- Euro Zone Purchasing Managers’ Index: -0.2 to 47.7 in May
- Japan Consumer Price Index: +0.9% year-over-year in April (core CPI increased 0.5% year-over-year)
- U.S. Durable Goods Orders: -2.1% in April (excluding transportation, durable goods orders unchanged)
What to Watch For
- Tuesday, 5/28:
- S&P Case-Shiller Home Price Index
- U.S. Consumer Confidence
- Thursday, 5/30:
- U.S. 1Q 2019 GDP (Second Estimate)
- China Purchasing Managers’ Index
- Friday, 5/31:
- U.S. Personal Income and Outlays
Statistics on the Current State of the Market – as of May 24, 2019
|S&P 500 Index||-1.1%||-3.9%||13.7%|
|Russell 1000 Index||-1.2%||-3.9%||13.9%|
|Russell 1000 Growth Index||-1.6%||-4.3%||16.1%|
|Russell 1000 Value Index||-0.8%||-3.5%||11.8%|
|Russell 2000 Index||-1.4%||-4.7%||12.9%|
|MSCI World Index||-0.9%||-3.5%||12.6%|
|MSCI EAFE Index||-0.5%||-2.9%||10.1%|
|MSCI Emerging Markets Index||-0.9%||-8.4%||2.9%|
|STOXX Europe 600||-0.9%||-3.3%||11.2%|
|FTSE 100 Index||-0.9%||-1.4%||10.5%|
|CSI 300 Index||-1.4%||-8.0%||19.7%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.1%||0.3%||1.5%|
|Citigroup 10-Year Treasury Index||0.6%||1.7%||4.2%|
|Bloomberg Barclays Municipal Bond Index||0.1%||1.0%||4.3%|
|Bloomberg Barclays US Aggregate Bond Index||0.3%||0.8%||3.8%|
|Bloomberg Barclays Global Aggregate Index||0.4%||0.8%||2.7%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.1%||-0.3%||7.0%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.1%||-0.7%||8.1%|
|ICE BofA Merrill Lynch Global High Yield Index||0.0%||-0.7%||7.1%|
|JP Morgan EMBI Global Diversified Index||0.2%||0.2%||7.4%|
|JP Morgan GBI-EM Global Diversified Index||0.5%||-0.3%||2.4%|
|U.S. Dollar per British Pounds||-0.3%||-2.6%||-0.3%|
|U.S. Dollar per Euro||0.4%||0.0%||-2.0%|
|U.S. Dollar per Japanese Yen||0.6%||1.9%||0.3%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.1%||1.6%||17.1%|
|FTSE EPRA/NAREIT North America Index||0.2%||1.8%||17.5%|
|FTSE EPRA/NAREIT Global Index||0.4%||0.7%||14.5%|
|Bloomberg Commodity Index||-1.2%||-2.2%||3.6%|
|Gold (NYM $/ozt) Continuous Future||0.6%||-0.2%||0.2%|
|Crude Oil (NYM $/bbl) Continuous Future||-6.6%||-8.3%||29.1%|
Source: FactSet, Neuberger Berman.