Invest in emerging markets. Benefit from the momentum.
Many equity markets in emerging economies are subject to sharp fluctuations. There is a big gap between successes and reverses. Overall, the emerging markets are seeing an upward trend, which offers continuing upside potential. How investors can best position themselves.
Emerging markets were under pressure in 2018
Emerging market equities came under pressure last year on a broad front. Many emerging market nations from all parts of the world suffered dramatic price reversals, resulting in the broadly based MSCI Emerging Markets Index losing around 15 percent of its value last year. Major contributory factors here included the financial and economic crisis in Turkey (stock market minus 43 percent in 2018) and the collapse of the peso in Argentina (stock market minus 36 percent in 2018).
Central banks in many emerging market countries were forced to step in to support their ailing currencies last year, especially as the dollar strengthened and trade tensions between China and the US resulted in tighter monetary conditions. Thich in turn weighed on growth expectations.
But there were also a number of winners among the emerging markets last year. Investors who put their faith in the stock markets of Qatar or Jamaica at the start of 2018, for example, ended the year some 30 percent up, while investors in Ecuador would have reaped a handsome return of 23 percent. This wide spectrum of successes and reverses reflects the different situations and success factors at work in the emerging markets. According to a study by Black- Rock, 75 percent of all emerging market equities fluctuate by more than 40 percent annually.
Economic environment in emerging markets is improving
The macroeconomic environment of the emerging markets continues to gain in potential, buoyed by growth acceleration and attractive valuations. Among other things, this improved economic situation is reflected in the Purchasing Managers Index, an internationally used leading indicator of economic development. Values above 50 indicate economic expansion, values below 50 economic contraction.
The Purchasing Managers Index for the manufacturing sector of the emerging markets has risen to 51 after hitting a low of 49.5 in January. Following the sharp correction in Q4 2018 and the rebound in Q1 2019, emerging market equities continue to trade at the lower end of their historical valuation bandwidth.
Emerging market equities remain attractive
Specifically, this means that emerging market equity valuations remain attractive in comparison with those of industrialized nations. The International Monetary Fund IMF is forecasting overall economic growth of 4.5 percent for the emerging markets in 2019. The Credit Suisse experts anticipate a similar figure of 4.4 percent and expect strong emerging markets to predominate over weak ones.
A look at the past shows that emerging markets have experienced prolonged phases of both overperformance and underperformance vis-à-vis the global equity market. Since 2017 the emerging markets have been in a relative upward phase, albeit punctuated by short-term reverses.
Emerging markets are becoming more flexible and more profitable
The current upward movement can be explained on the one hand by structural improvements in the emerging markets. Take, for example, capital spending on machinery and equipment by companies in emerging markets. This currently stands at 9 percent of sales, a much lower figure than just eight years ago at 14 percent. This means that companies in emerging markets now have to invest a lower proportion of their fixed costs in infrastructure. As a result, they have become more flexible, to an extent that is very comparable with companies in industrialized nations.
On the other hand, emerging market companies are now more profitable than their peers in industrialized countries. This much is apparent from cyclical factors such as the free cash flow returns of companies in the emerging markets, which have improved from 3 percent to 6 percent since 2014.