The apparent stability indicated by an essentially flat return for emerging-market indexes in the first quarter belies an extremely turbulent start to the year.
Risk appetites have closely followed a pattern set by commodities and emerging-market currencies, which began the year in free fall before staging their recent recovery. The fears concerning deteriorating growth prospects lessened toward the end of the first quarter, giving way to hopes of additional fiscal and monetary stimulus in a number of markets.
With the challenges facing emerging markets already widely understood, and with capital outflows from emerging markets pushing valuation levels close to all-time lows (as reflected by the MSCI Emerging Markets Index price-to-book ratio1), any evidence of a bottoming in economic and earnings data has begun to prompt investors to take a second look at the asset class. We believe we may be approaching a potential inflection point after which easier monetary policy and directed fiscal stimulus could provide a catalyst for better performance over the balance of the year.
Back to basics: opportunities in the BRICs
We continue to believe that a portfolio of well-managed companies with strong business models will outperform those companies that depend on a cyclical pickup in commodity prices. This is one of the reasons we continue to be optimistic about the long-term prospects some of the so-called BRIC markets—specifically, Brazil, India, and China.
The Indian government has produced an encouraging budget that adhered to sound fiscal boundaries, favoring reform over rural subsidies. Although the Indian market did not fare well last year, fundamentals are improving, and we anticipate continued progress as the legislative logjam subsides and the administration's prudent economic policy begins to yield results.
We also continue to be positive about the service economy in China as the country negotiates a path of structural reform while adapting to decelerating growth. From a valuation perspective, certain Chinese equities are trading at levels not seen since the global financial crisis in 2008–2009. Administrative measures to restrain wide fluctuations in capital flows appear to have restored some sense of rationality to Chinese currency assessments. We have also begun to view the long-term prospects for Brazilian corporations more constructively, given the current low valuations and possibility for any positive changes in real interest rates and GDP growth to provide an engine for gains in this market.
Macro-level risks pose the most significant threat to growth
The key risks for emerging-market equities lie less at the corporate or security level than at a macro level. The ability of governments to deliver structural reforms in an era of low economic growth will remain challenged, and the consequent impact on corporate profitability is a critical risk. It is also worth noting that within emerging-market economies, there remains a divide between those countries that have the ability and mandate to effect change and those that are trapped by fiscal imbalances made worse by dependence on commodity price movements. The strength of the U.S. dollar and the trajectory of U.S. interest rates will further influence emerging markets. From a sector perspective, we likewise remain cautious on those that are tied to commodity prices, given our belief that supply and demand have yet to regain equilibrium. All of this said, emerging-market equities have not seen valuations this low in years, and we believe positive surprises are far more likely than a further deterioration in company and economic fundamentals.
1 The price-to-book ratio is a ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.