Emerging markets delivered strong performance in the second quarter, driven by improved economic conditions and stabilized corporate earnings.1 The macro-level strengthening included lower inflation, stable commodity prices, improved current account balances and a reversal in currency depreciation. Assuming an accommodative monetary backdrop, emerging-markets gross domestic product (GDP) is expected to grow by roughly 4% this year and to accelerate in 2017 – the first acceleration in four years.2
Brexit fallout in emerging markets?
The impact of Britain’s vote to exit the European Union (EU) has been moderate, given that emerging markets have limited trade exposure to the U.K. and emerging-market exports to the EU account for only 4% of emerging-market GDP.3 Although global GDP has fallen post-Brexit, we have seen only minor changes to emerging-market GDP. Additionally, we believe the developed world is likely to see continued low interest rates. Low rates, coupled with slower growth in the developed world, have translated into currency strength in emerging markets. We believe this could be a catalyst for emerging-market equities and allow for a benign monetary environment.
Brazil’s markets on the mend?
Despite Brazil’s long, deep economic contraction, the Brazilian market performed strongly in the second quarter and has done well year-to-date.1 In fact, economic data suggest the recession may now be close to bottoming out. Brazil is also seeing renewed optimism on the strength of a recent change in government, a new economic team and signs of a shift in economic policy. Interim president Michel Temer’s government has announced a budget cap for 2017, with more measures to restore fiscal stability on the way. Despite the political situation in Brazil, our strategy, as always, is to focus on company fundamentals – particularly Earnings, Quality and Valuation (EQV).
Over the long term, lower wage rates, a weak currency and fiscal consolidation should help correct imbalances in the Brazilian economy. We are already seeing the process work, reflected in an improved current account and reduced inflation. If these trends continue, we should see normalization of interest rates and, more importantly, lower long-term borrowing costs. Brazil has some of the highest interest rates in the world, and rate normalization is critically important to economic recovery.
Emerging-market corporate earnings stabilizing
While downward-trending earnings have weighed on emerging-market shares over the last few years, earnings have stabilized of late. During the past few months, earnings revisions have turned positive in Brazil and Russia in local currency terms. The consensus earnings forecast for emerging markets in 2016 includes 7% growth – a sharp reversal from the double-digit declines of 2015. The forecast for 2017 is even higher, with 13% earnings growth projected in emerging markets.2 We may yet see downside earnings revisions. However, with profit margins likely at a nadir and currency levels stabilizing, the worst seems behind us.
Emerging-market valuations remain compelling
Despite the improved performance of emerging-market equities, valuations remain compelling. On a price-to-book basis, emerging-market equities are trading at 1.4 times earnings, which represents a 32% discount to developed-world equities versus an average discount of 10%.1 This discount is especially notable given the fact that emerging-market issuers are generating return on equity comparable to firms in the developed world.