By Wasif Latif, Head of Global Multi-Assets
Emerging market equities have been on a nice run over the past few months, and based on the trends we’re seeing in the market, this rally may have legs.
A couple of key factors are driving EM stocks, which as of the end of August were up nearly 15% year to date. This compares to 10.2% for U.S. small caps, 7.8% for U.S. large caps and less than 1% for non-U.S. developed markets.
The first factor is the same that’s hovering over pretty much every asset class: the Federal Reserve and its plans to increase short-term interest rates. On both the equity and the debt side, EMs have benefited from the Fed’s hesitancy to move on rates because this is keeping a lid on the U.S. dollar. Many EMs, most notably Russia and Brazil, rely on commodity exports that are priced in dollars, so demand tends to drop as the greenback strengthens.
A rate-hawkish speech by Fed Chair Janet Yellen in Jackson Hole, Wyoming, last month raised the odds of a rate hike at the Fed’s next meeting Sept. 20-21 and possibly another in December, and the sudden change in outlook rattled the market. A weaker-than-expected jobs report for August, however, and soft manufacturing data have knocked those odds back down.
As of Tuesday, based on the price of federal funds futures, the market believes there’s roughly a 50-50 chance of Fed action in December. The implicit odds of a hike increase into next year, but even then, the market expects the Fed to act only a single time before late 2017. Whether that one time comes in September, December or later, the impact on the dollar stands to be muted, which would represent a positive for EMs.
The other factor supporting EMs is more appealing fundamentals, and this is the one that could set the stage for a lengthy rally. At the end of August, for example, the ratio of current price to average earnings over the past five years was about 11 for EM, while U.S. large caps stood at 20 and developed Europe was close to 14. The price-to-book-value ratio for EM is also considerably cheaper compared to developed markets.
Behind the compelling P/E and P/B numbers is a pickup in economic growth, which is contributing to widening corporate profit margins and a better liquidity picture. The Chinese yuan is down more than 2% against the U.S. dollar so far this year, which has boosted its important export sector. China’s demand for commodities has, in turn, increased, and this has been a modest positive for EM countries dependent on commodity exports.
The Asia-Pacific region, which is by far the largest EM region, has been a stronger market than either Eastern Europe or Latin America. Much of the difference comes down to Asia being primarily a commodity consumer, while the other two regions are dominated by commodity producers.
Our portfolios have a slight overweight to EM, based mostly on valuation. We’re looking for signs that the current corporate profitability trend is sustainable, which would tell us that EM may be setting up for longer-term outperformance relative to developed markets. Under that scenario, we would continue to build our EM overweight.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for you based upon your individual goals, objectives, risk tolerance and time horizon.
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