Emerging Markets, Asia and Japan
Returns from Emerging Market equity markets have been disappointing this year with the Investment Association Global Emerging Markets sector average falling by 6% to the end of June, by far the worst regional return. The second quarter was particularly torrid with some EM currencies suffering big falls and a significant widening of spreads in EM bonds in addition to equity market weakness. There have been a number of external headwinds, notably tighter US monetary policy and the strengthening US dollar, whilst Asia is a major victim of the escalating Trump vs. China trade war. EM equities and debt are seen as amongst the riskiest of asset classes and so would suffer should markets see a long-lasting ‘re-pricing of risk’ as developed market bond yields rise.
There has been a wide divergence in returns from the individual markets, especially when the weakness of some EM currencies is taken into account. The MSCI EM index is down 5% in sterling terms but splitting it down by individual MSCI country indices tells a different story. Russia is actually up 5%, China is down only but 1% and India 4% but Brazil has fallen a whopping 15%.
These returns are particularly disappointing because there are a lot of reasons to favour Emerging Markets. Global growth remains firm, inflation under control, and corporate profitability continues to improve as global demand recovers and the companies themselves improve their financial discipline. Earnings growth is forecast to be mid-teens this year, broadening out from last year’s growth which was a spectacular 20% in aggregate but very technology centric. This year financials, industrials and consumer stocks are coming to the party as well. Valuations remain supportive at 11.5x forward earnings, still a significant discount to the developed markets with the MSCI World index trading on 15.5x. Sadly for investors, the bearish external trends are swamping the bullish internal fundamentals.
China grew at 6.8% in Q1 driven by better than expected retail sales, in line with the Government’s long term aim of rebalancing the economy away from traditional manufacturing industries. Growth is expected to slow in the rest of the year as stricter controls cool the property market and Beijing clamps down on local authority spending and debt. Front and centre for markets is not the growth numbers but the simmering trade war with the US. In the background is the extent to which the PBoC wishes to tighten monetary policy. Chinese monetary policy remains an overlooked but very influential driver of financial markets and was in large part their saviour post the financial crisis in 2008.
What was it that Churchill said about Russia? “A riddle wrapped in a mystery inside an enigma” and much the same goes for the Russian stock market. You make the most money at the point of most acute bearishness and maybe that is where Russia is now following the imposition of US sanctions in April which made Russia increasingly an international pariah. Stocks trade on a forward P/E of about 6 times which is half the EM average which itself is a 30% discount to developed markets. Fundamentals aren’t totally disastrous with Russia now out of recession and inflation back under control but the problem is of course the geopolitics which remains fraught with risk.
The fundamentals look supportive for Japan which continues to be the darling of the ‘value’ crowd to such an extent that it is becoming a consensual asset allocation rather than the contrarian outcast it has been for the last twenty five years. Decent earnings growth, structural reforms, a stable and supportive political and monetary environment, much improved corporate governance and increasing flow of both domestic and foreign money into the stock market are all tailwinds. Japan is a particular beneficiary of stronger global growth and had notched up seven consecutive quarters of GDP growth, the best run for decades, before a 0.2% fall in Q1 this year snapped the streak. Hopefully this is a blip rather than a trend though growth is expected to be only around 1% in 2019. Earnings growth is expected to be in double digits this year, and the market P/E is 14x, relatively inexpensive by global standards, with a dividend yield of 2% which is a sea change from the previous experience of companies hoarding huge cash piles. Risks are of the ‘big picture global’ variety such as a slowdown in the global economy, trade wars escalation, a sharp rise in US Treasury yields or at the domestic level an unexpected volte-face in the direction of BOJ monetary policy or a stronger yen.
Summary: Emerging Markets have produced very disappointing returns this year as they face strong external headwinds, notably tighter US monetary policy, a strengthening US dollar and the tariff war between Trump and China. These markets remain best suited to higher risk/reward investors with a long term time horizon and acceptance of a high level of volatility.