EM equities are enjoying a strong rebound following five years of underperformance versus developed markets. In this piece, Barings’ portfolio managers explain why they maintain an optimistic outlook for the asset class.
The case for emerging markets equities
After five painful years of underperformance by almost 50% in U.S. dollar terms versus developed market equities, emerging markets equities enjoyed a rebound in 2016 that followed through into 2017. The question on every investor’s mind is: Can it be sustained or is it just another false dawn? At Barings, we believe there are grounds for optimism, a view that centers on the outlook for corporate earnings.
We need only to observe the performance from 2011 to 2015 to appreciate how powerful the earnings cycle is as a driver of stock market returns in emerging markets. During this period, earnings expectations peaked at the beginning of each year before experiencing a steady and sustained decline as companies failed to meet analyst forecasts. This proved to be a major headwind for EM equities, which declined by more than 30% in U.S. dollar terms over this period. This pattern only changed in 2016 and 2017.
So what impacted EM corporate earnings during this period and has anything changed? Over the course of 2011 to 2015, EM companies suffered a double whammy of falling profit margins and slowing sales growth. Profit margins declined because real wage growth exceeded productivity growth, while sales performance was negatively impacted by weaker nominal GDP growth. The end result was that EM corporate earnings failed to grow over the five-year period from 2011 to 2015 and, unsurprisingly, the MSCI Emerging Markets Index also failed to make any progress.