This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
Given the strong recovery witnessed in 2017, many investors wonder if emerging market equities have further room to run in 2018. The asset class saw a record inflow of $80 billion in 2017, and valuations are currently at a seven-year high since 2010, at 14.7x price-to-earnings, and 1.8x price-to-book ratio as at end December 2017.
But we believe these valuations are fundamentally supported by earnings growth. After emerging market corporate earnings reached an inflection point in 2016, the return on equity of emerging market companies continued to outpace developed markets. We see better visibility in emerging market corporate earnings forecasts and believe earnings still have further upside.
Moreover, many emerging economies have been in the expansion phase, with countries such as Russia and Brazil coming out of recession, and new policy reforms paving way for stronger economic fundamentals. The tailwinds of higher commodity prices also benefit many economies, such as Russia.
Despite a narrower valuation gap, companies listed in emerging markets continue to trade at a discount relative to developed markets. Emerging markets are growing in economic significance globally, and the current momentum is showing little signs of abating despite potential economic and political headwinds.
Emerging Markets at Forefront Global Change
Emerging markets are at the forefront of a changing world, and old economic models are undergoing a transformation, paving the way for new and exciting investment opportunities. More pertinent to the long-term growth of intra-Asia trade is China, as the country transitions to a consumption-based economy, opening-up new opportunities for trade in the Asian region.
Below we explore the core themes of technology and consumer, with new sub-themes identified: e-commerce, new mobility vehicles, fintech, penetration, “premiumisation” and health care.
How Emerging Markets are a Tech Play
Despite the correction seen in technology names after the third quarter of 2017, we remain positive in this sector. Opportunities for efficiencies, cost savings and ease of doing business are supported by emerging markets’ accelerating internet usage and penetration. The MSCI Emerging Markets Information Technology Sector Index rose 60.9% in 2017 as investors were drawn by the secular trends including e-commerce, gaming and cloud computing.
The semiconductor industry has gained strong prominence over the years, catering to the increased demand for automotive chips, wireless infrastructure, sophisticated electronic devices and other major applications.
E-Commerce Continues to Accelerate
E-commerce is still very much a penetration growth story, resonating in several markets as consumers increasingly use multiple devices for online shopping. Traditional ways of doing business are losing ground to the digital revolution, which introduces new innovative ways to personalise a shopper’s experience.
To illustrate, Alibaba (BABA) has employed big data in its algorithm since September 2016, enhancing personalized and real-time recommendations, and improving click-through rates. Such firms are favoured due to their greater ability to monetise their businesses.
Furthermore, the high growth rate of digital commerce has also caught the attention of social media firms – Russian internet search giant Yandex (YNDX) for example has recently announced an online retail joint venture with Sberbank Bank (SBER), with hopes to tap into its enormous customer base.
New Mobility is Disrupting Industries
Technology is also shaping the automobile industry, introducing new trends such as electric vehicles and automated driving systems. There have been several partnerships over the past few years, such as the Beijing Automotive Industry Holding Company collaborating with both Baidu and Alibaba on autonomous driving software. Component manufacturers are also joining this trend as we see new mobility as a long-term theme.
Fintech is Driving Inclusion
Over the past year, there has been greater adoption of fintech solutions globally across emerging markets, including China, India, South Africa, Brazil and Mexico. Fintech firms have become successful at tapping into the tech literate but financially underpenetrated populations. Tech names have also explored into this field, with the likes of Tencent (00700) introducing its online payment platform, Tenpay.
Demographics and Consumer
The structural case for emerging markets continues to centre around demographics, a rising middle class and domestic consumption.
Penetration
We believe the demand for goods and services is set to accelerate on the back of a burgeoning young and working population in emerging markets coupled with rising household incomes creating opportunities for businesses that tap into this growing consumer market.
Premiumisation
The growing disposable incomes of emerging market consumers help drive aspirational demand for higher-value items—a phenomenon known as “premiumisation.” Consumers are demanding better quality of goods and services, including entertainment, resorts, movie theatres, gaming and travel.
Shifting health care landscape
Demographic shifts and societal changes have intensified pressures on health care systems, and more hospitals and physicians are taking steps to improve services provided to patients. Increasingly, affluent consumers also boost the demand for aesthetic plastic surgery and weight management. There is also a push toward preventive care, including a focus on nutritional products.
Perhaps the most pressing issue for health care in developing countries is the rise of aging populations. According to United Nations’ World Population Prospects: The 2017 Revision, the number of older people—those aged 60 years or older—is expected to more than double by 2050 and more than triple by 2100. Globally, population aged 60 or over is growing faster than all younger age groups.
Summary
We expect emerging market equity momentum to continue in the second half of the year despite potential headwinds – including uncertainty surrounding the US administration’s policies, faster-than-expected Fed rate hikes, and higher bond default rates if systemic liquidity tightens.
However, it is important to note that emerging markets are not homogenous, they have their own idiosyncratic domestic drivers, so are less correlated to one another and the global market as a whole.
Many emerging markets also have stronger foreign reserve positions and lower external debt today, making them potentially less vulnerable to external shocks. Moreover, intra-regional trade has become far more important in recent years and protectionist sentiment may only pivot focus toward greater regional agreements, such as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).
Furthermore, the direction of the US dollar itself is far from certain—should the administration aggressively pursue polices to boost exports and manufacturing, it may be accompanied by a weaker USD. In our view, we are still in the early innings of the emerging market earnings growth upturn, and valuations and sentiment continue to be conducive to further gains in the asset class. Emerging markets are increasingly taking the global stage, and it is an opportune time to be at the forefront of a changing world.
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