Emerging market equities may be good investments next year

Emerging market equities, which have had a torrid year because of China’s economic slowdown and expectations of a US interest rate rise, could present a good investment opportunity in the coming year because of attractive valuations and signs of economic improvement.

The end of quantitative easing by the US Federal Reserve, and its decision to raise interest rates in the middle of this month, contributed to negative investor sentiment on emerging markets this year. Emerging markets cumulatively have suffered their first year of net capital outflow since 1988, with the Institute of International Finance projecting a capital flight of US$541 billion.

The MSCI Emerging Market index has fallen 17 per cent during 2015, compared to the negative 3.5 per cent performance by the MSCI World Index.

At a time when investor expectations for emerging market corporate earnings are at their lowest ebb, we have raised our allocation to emerging market equities to “overweight”.

We believe the pessimism is excessive. Valuations for emerging market equities have become attractive, and are now trading at just over 12 times forward earnings, a third cheaper than the S&P 500.

And at the same time, economic conditions across the developing world are stabilising, and the stage is set for an end to the four-year decline in corporate earnings.

The Chinese economic slowdown had a knock-on impact on other Asian economies, and a recovery should have a wider positive effect.

We are already seeing signs of the long-awaited “rebalancing” of the world’s second-largest economy, with the Chinese consumer starting to pick up the slack from the traditional growth engines such as export manufacturing and property development. Higher wages, prompted by a shrinking workforce, is spurring consumption, with retail and car sales both growing in double digits in recent months.

The capital flight from emerging markets is in essence because of the unravelling of flows in the other direction, provoked by three rounds of US quantitative easing that began in 2008, which led investors to search for higher yielding investments in the developing world.

The argument goes that the Fed’s decision to raise interest rates for the first time in almost a decade will now mean a stronger dollar, continued low commodities prices, and Asian currency weakness. But because markets react far in advance, especially of such a well-signalled move, this scenario has already largely played out.

Furthermore, the curtain has certainly not fallen on the era of loose global monetary policy, with the Fed insisting it will tighten the monetary reins gently, and Europe and Japan likely to continue with their efforts to stimulate the economy.

Indeed, in addition to emerging markets, we are also positive on the outlook for European and Japanese equities next year, while US stocks could well underperform.

Our forecast is for another quarter of earnings declines in the US before a recovery. Even then, higher interest rates and slowing economic momentum are likely to make conditions more challenging for US companies to outperform their peers elsewhere in the developed world.

Euro zone and Japanese stocks are relatively inexpensive, many companies have seen their global competitiveness boosted by weaker currencies, and this advantage is likely to endure due to exceptionally supportive monetary policies.

On a valuation basis, European stocks are the most attractive of any developed markets at this point, both compared to bonds and on the basis of normalised corporate earnings. What is more, euro zone equities are trading at their lowest level to date relative to their US peers in US dollar terms.

Lucas Paolini is the chief strategist at Pictet Asset Management.


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