Emerging markets have experienced a long spell of gloom, but we believe their underperformance relative to developed markets has run its course, thanks to a variety of factors, including that valuations, flows, the U.S. dollar are supportive, and corporate fundamentals are improving. Let’s look at each of those trends in more detail.
Valuations Are Generally Attractive
Emerging markets are trading at an approximate 25% discount to developed markets, which is one standard deviation below their long-term average. At 11 times forward-12-month earnings (on an absolute basis), emerging markets are trading in line with their longer-term average while developed markets valuation stands at the high end of the 10-year trading range.
Moreover, an analysis of historical performance shows that on a rolling five-year annualized basis, emerging markets have posted negative returns on three occasions over the past 40 years: the late 1990s amid the Asian financial crisis and the Russian default, the early 2000s with the dot.com bubble, and the last few years when we saw an extended period of underperformance.
Flows Are Supportive
As interest rates have continued to decline in developed markets, and almost a third of bond yields are in negative territory globally, the search for yield has benefitted emerging markets. The differential between bond yields in emerging markets and developed markets is at a 10-year high, and is increasingly attracting flows into emerging market debt. These flows have accelerated dramatically since the United Kingdom’s Brexit vote.
Foreign flows are very important for emerging markets, especially for countries that have a current account deficit, as they help alleviate pressure for funding the negative current account balance. They also support emerging market currencies, reducing pressure on central banks to raise rates.
Yet, investors are still relatively underweight emerging markets versus their historical positioning. Even after the positive flows we saw recently (approximately $4.5 billion was deposited to emerging market equities in a single week in July, for example), we believe we are in the very early innings of investor repositioning, and there is ample room to recover from the $50 billion in outflows experienced in 2015 and close to $90 billion in the past five years.
The U.S. Dollar Is Supportive
Another supporting factor for emerging markets has been the relative weakness in the U.S. dollar this year compared with the sharp appreciation of the last few years, which was a clear headwind for emerging market investors. This year, many emerging market currencies are among the strongest-performing globally, and from a broad perspective they have stabilized following a tumultuous period.
Corporate Fundamentals Are Improving
Corporate fundamentals are our main focus on William Blair’s Global Equity team. We spend a significant amount of time on the ground meeting with companies, and our conclusion from recent contacts is that the environment is broadly improving or at least stabilizing. This is confirmed by underlying data from our quantitative models. As the chart below shows, earnings revisions in emerging markets bottomed in March and April of 2016, and we’ve seen two to three months of steady improvement (versus the opposite in developed markets, with the United States, United Kingdom, and Japan rolling over in the past few months).