Emerging Markets: Don’t Be Spooked by Bleak Headlines

Signs of a recovery in emerging markets early this year have given way to worries about China’s economic slowdown and sluggish growth in Europe and Japan. But beyond the negative headlines we think many risks that weighed on the market last year have faded and the earnings outlook is relatively strong.

Will the 2019 Rebound Continue?

Last year was not kind to emerging-market (EM) investors. Escalating trade tensions between China and the US, as well as higher Fed rates and a strengthening dollar led to a painful correction in EM assets, particularly stocks.

EM capital markets snapped back sharply early this year. With Fed rate-hike expectations evaporating, rising hope for a US-China trade agreement and the prospect of China stimulus, EM returns improved considerably in January but paused in February and March. We expect the recovery to continue, though it will inevitably be a bumpy ride.

Relative valuations and corporate earnings growth prospects give us further confidence. The valuation of EM stocks is about a third of their developed-world peers. That discount is particularly compelling given the faster expected earnings growth in EM over the next 18 months compared with developed markets. While earnings revisions are coming down everywhere, EM earnings are expected to grow by 10% over the next 18 months, outpacing global earnings by about two percentage points. And corporate earnings margins in the developing world are well below their developed-world peers, leaving considerable room for expansion.

The greenback’s robust performance in 2018 has been painful for external EM financing needs. But the US dollar has now reached an extreme valuation level, in our view. In fact, its valuation versus a trade-weighted basket of currencies has not been this high since the mid-1980s. We believe this trend is unlikely to continue and may well reverse, providing yet more support for EM assets.

If history is any guide, EM stocks may deliver strong returns in 2019. That´s because in the past, when EM companies´ earnings significantly outpaced returns in a given year, the market often rallied in the following year.