Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Adrian Lowcock, head of investing at AXA Wealth asks whether the factors driving an emerging market recovery are sustainable
After five years out in the cold, emerging markets staged a rally in February this year. Does this mark an inflection point - or is there worst to come for emerging markets.
Emerging markets are often characterized by long periods of outperformance followed by periods of underperformance. The sector had a strong bull run following the 1998 Asian Crisis. Even the global financial crisis didn’t hamper the sector for very long as the asset class rebounded quickly as investors focused on the strong GDP growth from the region.
However, since 2011 emerging markets have lagged behind developed markets. Over the past five years these regions have returned 59% less than developed markets.
Emerging markets have suffered from three main problems: lower commodity prices, a strong US dollar and weak company profitability.
Commodity prices have moved in lockstep with emerging markets over the past five years leading markets lower. Emerging market currencies have been falling against a strong dollar. A strong dollar is not good for emerging markets as much of the debt in these regions is priced in dollars - so the size of this debt rises with the dollar. To make matters worse, as US interests rise, the cost of servicing the debt also goes up.
Finally company profitability has not kept up with GDP growth, so whilst emerging economies have been growing companies return on equity has been in constant decline since 2008.
Emerging Market Valuations Look Attractive
The rally in February came at a point when valuations in emerging market started to look very attractive. The price to book in February fell below 1.2, which looks cheap relative to emerging markets' own history. At the same time commodity prices began to recover, the US dollar weakened and a change in government in Brazil all helped to trigger a rally from the lows seen at the start of the year.
So are emerging markets at an inflection point? For the recovery to be maintained the reasons for the rally need to remain in place.
It is difficult to say whether the US Dollar has peaked, the Fed looks set to continue to raise interest rates, albeit at a slower pace, and the US dollar has recovered much of the ground it lost at the start of the year. Whilst commodity prices are difficult to predict, there is still significant oversupply and it looks unlikely that China will raise demand as the economy continues to slow down.
Could Company Profitability Hold Back Emerging Markets?
However the key issue is the return on equity mentioned earlier. Whilst valuations might be cheap, earnings have fallen so much that this may justifies a lower price to book valuation. In fact looking on a p/e basis emerging markets look to be fairly valued at around a p/e of 11.7, their historical long term average.
Emerging markets might look attractive, particularly compared to developed markets which are trading at high p/e ratios and above their own historical long term averages.
However until emerging market profitability changes direction, valuations are likely to remain suppressed.
Take Slow And Steady Approach
For patient investors who can wait a year or two until the turn around begins and are able to drip feed money into the market, emerging markets do look good value.
At the same time investors can access emerging markets selectively through actively managed funds where the manager can pick those companies. This should be able to pick stocks which are not as exposed to the sensitive areas of the market and have a more attractive return on equity, as well as focusing on those companies using technology to provide a competitive advantage.
There are opportunities but it may still be a while before we see a more pronounced change to longer term treands in emerging markets.
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