If It’s All About Macro These Days, Why Haven’t EM Stocks Done Well?
It doesn’t seem to make sense. Superior macroeconomic fundamentals in emerging countries have not led to stronger—or even positive—equity returns over the last two years. Since the beginning of 2011, the unhedged return in US dollars of the MSCI Emerging Markets (EM) Index has been (10)%, while the MSCI World Index has delivered 6.5%. What’s going on?
The answer is simple: Even in a time when the markets are highly sensitive to news about macroeconomic developments and government policy in developed markets, investors still pay attention to earnings. And while economic growth and corporate sales and profit growth rates remain higher in emerging markets than in developed markets, the sharper economic deceleration in emerging economies has led to an even sharper deceleration in earnings.
Emerging-market sales growth has generally kept pace with economic expansion, but profit margins have shrunk due to rising costs, particularly for commodities and wages. In developed economies, by contrast, sales growth has been sluggish, but companies have been better able to sustain margins. Their greater orientation to service industries and higher value-added businesses have made developed-market companies less susceptible to commodity-price pressures, while their stronger bargaining power with labor has allowed them to keep a lid on wage growth.
Investors in emerging markets have still been able to profit from superior macroeconomic fundamentals—if they’ve owned bonds as well as stocks. The JP Morgan Corporate Emerging- Market Bond Index (denominated in US dollars) has returned 25% since the beginning of 2011. Investors have rewarded emerging-market corporate bonds’ appealing combination of lower balance sheet leverage and higher yields. Lower leverage is great for bondholders, but not necessarily ideal for shareholders.
What’s ahead? Recent PMI surveys above 50 across emerging economies as diverse as Brazil, Mexico, India, Russia and Turkey point to favorable near-term momentum. But the sustainability of growth in these and other emerging countries will hinge on a recovery in global growth, in our view. There are also signs in some countries that domestic credit expansion is hitting its limit.
With the consensus estimate calling for 13% earnings growth in emerging markets next year and the MSCI EM trading at just 10 times 2012 earnings, investors could reasonably expect annualized returns in the low double digits over the next several years, if the consensus estimate proves accurate. To the extent that corporate debt issuance in emerging markets continues to be heavy, increased financial leverage could drive even faster earnings growth and stronger equity returns.
This increased leverage, if it occurs, would not necessarily hurt emerging-market bonds. Since corporate balance-sheet leverage in emerging markets is generally reasonable, additional debt issuance needn’t undermine the creditworthiness of emerging-market corporate debt. Strong expected demand is likely to keep corporate bond yields relatively low, allowing issuers to reduce their interest expenses.
With the yield on emerging-market corporate bonds currently at about 5%, it’s hard to imagine returns rising much higher, but the lower expected volatility of bonds would still make the asset class an important complement to equities. A wider range of new issues also creates an opening for investors in emerging-market stocks and bonds to make opportunistic plays on individual companies’ capital structures.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Morgan Harting leads the Emerging Markets Multi-Asset portfolio team at AllianceBernstein.