Emerging market (EM) equities have had a great run recently. But don’t buy EM stocks indiscriminately. Focus on company earnings over macroeconomic trends to find stocks that have stronger return potential with reduced risk.
The MSCI Emerging Markets Index has surged nearly 42% in just 21 months. That’s almost double the performance of the MSCI World Index of developed market stocks. After several tough years, EM are finally living up to expectations and unleashing powerful pent-up return potential.
What’s behind the strong momentum? It’s really all about earnings, and less about macroeconomics. In fact, contrary to conventional wisdom, the correlation between GDP growth and stock performance in EM is close to zero. On the other hand, the relationship between earnings and stock price is much more closely linked (Display).
That makes sense. Equity investors are ultimately investing in companies, not countries. And at the moment, the earnings outlook for companies in the developing world is robust, with consensus expectations projecting a 30% increase over the next two years.
PAY ATTENTION TO EARNINGS EXPECTATIONS
Changes in expectations are even more important, especially if stock prices already reflect a rosy outlook for earnings. Shifting expectations explain why EM returns were lackluster for several years and then strong more recently, as indicated by the recent rebound of earnings revisions (Display, left).