EMs started 2016 on a weak note as equities were buffeted by concerns surrounding China’s economy and falling oil prices. However, as the year progressed, positive factors took hold of investor sentiment, leading to EM strength and building, we believe, a robust foundation for EM equities as we look toward 2017.
Following recent improvements, we expect macroeconomic advances to continue in 2017. This could bode well for top-line growth opportunities and the earnings outlook for EM equities. We believe that, while GDP growth in a number of EM countries has been gaining ground, it is likely that over the next few years we could see further relative advances in sizable economies like Russia and Brazil. The economies of these two countries are still contracting, but they are on an improving trajectory and could significantly influence the growth rate of the whole group if they continue to progress. Meanwhile, China’s growth, which has been a key concern for many observers, has shown signs of stability and remains at a strong level compared to most other large economies. In the third quarter of 2016, the country’s year-on-year growth in GDP came in at a rate of 6.7%, which was in line with the pace reported in the previous two quarters.
Overall, we expect to see GDP growth for EMs in 2017 at a solid and accelerating level, markedly above the rate expected from DMs. EM countries are still far behind their DM counterparts when it comes to overall GDP-per-capita, and so we continue to expect strong growth prospects over the long term.
Additional economic factors are, we believe, important to our expectations for likely further strength in EMs.
First, as a group, manufacturing economies are generally back into a position of current account surplus, while there has also been headway in bringing down the deficits of commodity-exporting countries. Second, the debt-to-GDP ratios of EM countries are generally below those of DMs, providing a more stable and, we believe, sustainable economic foundation. Finally, interest-rate differentials between the two groups are wide, giving EM central banks greater flexibility to maneuver, if required, in the future.
The “hunt for yield” has been a frequently used term in recent years, yet the issue still remains front and center for many market participants. With low and negative yields on many government bonds globally, we continue to expect investors to look toward EM equities, given the income prospects available. For example, the dividend yield was an eye-catching 2.5% as at 31 October 2016 for the MSCI Emerging Markets Index. Year-to-date flows toward EMs have been positive, partly due to the attractive income expected. However, this follows three years of outflows, and so further moves into EMs could be another of 2017’s trends to look out for.
In terms of valuations, the MSCI Emerging Markets Index has traded at a significant discount to the MSCI World Index, for example, on a price-to-earnings-multiple basis. Earnings growth trends have improved markedly during. 2016, and we expect this turnaround to continue, with economies and corporate fundamentals across the asset class stabilizing.
We believe that companies in the consumer-related and IT sectors are particularly attractive in the current environment. Select stocks in the consumer sectors can provide an effective means to gain exposure to EM economic expansion and, in particular, access to growth in spending as rising regional wealth fuels a burgeoning consumer class. IT in particular is becoming increasingly integral and competitive in EMs, and, although we are cautious of the recent rapid share-price advances in many of the China-based Internet stocks, we see value in the sector across EMs as a whole. Elsewhere, select commodity shares remain attractively valued, in our view, even though oil prices, for example, are currently significantly above their 2016 lows.
We remain cautious of China’s banks as non-performing loan recognition dampens our outlook for the country’s financial firms. Like banks, China’s real estate sector has staged a striking turnaround from a lengthy downturn, but we have remained on the sidelines, in part due to risks of overleverage and regulation.
We continue to like Asian small-capitalization stocks as they are particularly exposed to the solid growth potential we expect from this region over the long term. This is helped by small-cap companies’ generally greater domestic focus than their larger peers, binding them less to challenging macroeconomic factors at a global level. Their valuations typically reflect the stronger growth expected from the smaller equities, but, given there are thousands of small-cap stocks in Asia, the opportunities to discover mispriced securities are often plentiful. These valuation anomalies usually occur due to market inefficiencies as research coverage for many of these companies can be thin on the ground.
Fed monetary policy is still a source of apprehension for many participants in EMs. We expect the trajectory of any rate increases to be gradual, although larger-or faster-than-expected US interest-rate moves could dampen sentiment and lead to volatility. Other meaningful tests for the global economy may include geopolitical troubles, currency fluctuations, the UK’s progress toward leaving the EU and commodity-price moves. Meanwhile, recent political events in the United States may also test markets; the US presidential election victory for Donald Trump is likely to have many implications for markets around the world, including EMs, and may well add to volatility in equities. It is something we will continue to monitor closely. However, we believe it will be important for investors to take a long view and not be swayed by short-term gyrations that we could continue to see in financial markets.
By Stephen H. Dover, CIO, Templeton Emerging Markets Group & Franklin Local Asset Management
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