Emerging-market (EM) stocks have suffered from a Trump-induced hangover after surging through the first 10 months of 2016. We think investors should put the new risks into perspective.
It’s been a rough month for EM equities. Since the US election, the MSCI Emerging Markets Index has fallen 3.8% in US-dollar terms through December 7th, trailing the MSCI World Index of developed-market (DM) stocks by 7.4 percentage points. It was a sharp reversal from the first 10 months of 2016, when EM stocks rallied 16.3%, ranking among the world’s top-performing assets.
Their rally was driven by several positive developments. Following several years of underperformance, EM valuations had become very attractive versus DM stocks. Growth prospects were better than the relatively anemic ones in DM countries. Inflation had moderated and, in many countries, political reform was unfolding. Corporate earnings had begun to grow again and investor flows had started to return.
Trump Election Battered Sentiment
Overnight, everything seemed to change when Donald Trump was elected president. The dollar strengthened, and a shift toward higher US interest rates appeared to accelerate. Fears of US protectionist policies triggered a collapse in currencies in countries such as Mexico and Brazil.
These dynamics are generally viewed as unfavorable for EM countries and companies. But before giving up on EM, we think some perspective is warranted in three areas in particular:
Rising US interest rates are not automatically bad for EM: If interest rates rise because of strengthening economic growth, we believe emerging markets can benefit from the trend. Indeed, expectations are growing that the new administration will foster fiscal spending policies that can lift growth in the US economy. This should deliver broad benefits to EM countries and the world economy. From 2004 through 2006, for example, when the Federal Reserve raised interest rates from 1% to 5.25%, EM stocks rose more than 120%, far outpacing the return of DM stocks.
Countries and companies are not equally affected: Not all countries, sectors or companies will be affected equally by the shifting market and policy environment. Mexico’s and South Korea’s export-driven economies are obvious potential victims of US protectionism. But Russia has done well on expectations that a Trump administration will be more friendly toward the resource-rich nation, which would also benefit from hopes of greater infrastructure spending and reflation. Even China has outperformed the EM index recently, because many domestically focused companies there simply don’t rely on global trade and aren’t really affected by developments outside of China. And while weakness in EM currencies can be painful for companies with significant dollar-denominated debt, it can benefit those with overseas revenue, as profitability in local-currency terms improves.
Campaign promises ≠ government policy: It’s too early to determine whether Trump will turn all his policy initiatives into policy. If some of the more radical proposals are watered down or scrapped, many EM countries and companies could rebound.
Attractive Earnings and Valuations
The earnings outlook for EM companies remains attractive. Despite modestly lowered forecasts since the election, consensus analyst estimates still indicate earnings per share growth of more than 13% next year for the MSCI EM Index. That leaves EM stocks trading at 11.8 times next year’s forecast earnings—25% lower than the 15.7× multiple for the MSCI World Index of DM stocks (Display).
Attractive valuations of EM stocks have created another opportunity for investors who missed the rally earlier this year, in our view. The uncertainty has also created significantly greater dispersion between and within countries and sectors.
Actively Navigating Geopolitical Risks
We think active approaches are best suited for the EM environment today. Active strategies can avoid stocks that are most vulnerable to unfolding geopolitical events while taking advantage of market overreactions. And passive strategies will leave investors exposed to the riskiest parts of the market.
It’s tempting for investors to give up on EM stocks during such turbulent times. But in fact, the long-term outlook for emerging markets appears to be more robust than indicated by recent market performance. By positioning selectively in companies that are relatively immune to risks emanating from Washington, we believe investors can turn a period of significant uncertainty into a great buying opportunity for EM stocks.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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