Key indicators reflect brighter outlook for emerging-market equities

Although emerging-market equity indexes have posted volatile and mostly negative returns since climbing to their postfinancial crisis peak in April 2011, the asset class has become increasingly attractive in recent months.

Initial apprehensions related to Donald Trump's victory in the U.S. presidential election soon gave way to a more sanguine view of the world, as expectations for rising inflation and accelerating economic momentum grew. The U.S. dollar strengthened, as did anticipation that the U.S. Federal Reserve (Fed) would move ahead with its plans to normalize interest rates following its approval of a rate hike in December 2016.

Positive signs for emerging-market equities

These developments support our view that the global growth outlook is unlikely to weigh on emerging-market equities. The governments of many emerging markets (EM) have worked hard to adjust their budgets to the evolving realities of the global economy, and we have seen encouraging signs that key EM economies are continuing to implement structural reforms.

As for economic trends, business activity across the EM climbed in December to its highest level in 27 months,1 and recent interest-rate cuts by central banks in India, Brazil, and Indonesia reflect the view that inflationary pressures within the EM universe remain controlled.

China, a key pillar of the EM world, has recently continued to display signs of economic stabilization. Crucially, the Chinese government still has the flexibility to effectively administer monetary and fiscal policy, and there is good reason to believe the country will meet its growth targets, as planned infrastructure spending begins to be deployed and Chinese consumers remain active. Importantly, China's recent initiatives to rationalize its industrial capacity suggest the government remains committed to supply-side economic reforms.

These developments generally aligned with our expectations entering 2016, when we noted several developing trends that could influence the earnings recovery in EM2; today, those trends appear to be in the process of becoming more defined. Commodity prices have stabilized, and we have seen improvement in corporate margins and in asset turns-a gauge of how efficiently a company uses its assets, as measured by its sales expressed as a ratio to its assets. These improvements have led to increasing evidence of genuine improvement in profitability.

Emerging-market fundamentals appear to have bottomed

Overall, we continue to believe that EM equities are poised to perform strongly in the coming quarters, and, at the very least, perform well relative to their developed-market peers. We maintain a favorable outlook in China, which we consider to be an under-owned market, and companies that appear poised to benefit from China's shift toward the “new economy” are of particular interest. In India, a favorable macroeconomic environment, stabilizing corporate results, and important government-led reforms have supported investment opportunities, in our view.

Potential risks on our radar

We remain committed to identifying high-quality companies that offer high return on equity and high free cash flow growth, particularly in light of the volatility that is associated with the EM asset class. Political risk is one of a number of variables that may complicate our generally positive EM outlook, although, ironically, the developed world appears to present risks that are equal to—if not greater than—the risks that EM present.

The U.S. presidential election's outcome carries potential implications for the U.S. dollar and geopolitics as well as for global trade. Even the apparent certainty of the U.K.'s pending exit from the European Union creates uncertainty as to the impact on European economies and their interaction with the wider world. Finally, possible further action by the Fed in coming months to normalize interest rates will be important in determining whether a range-bound U.S. dollar will continue to be supportive to the EM asset class.

 

1 IHS Markit, Emerging Markets Purchasing Managers' Index, January 2017.

2 John Hancock Asset Management, Global Intelligence 2016–Year Ahead, December 2015.