Bulls Lock on to Emerging Market Promise

Emerging stock markets suffered a disappointing start to the year. Despite healthier economic growth, bourses in the developing world largely failed to better the performance of mature stock markets. Can they turn things around in the second half?

Beijing, China
Keren Su | Getty Images
Beijing, China

There are plenty of investors and analysts who are optimistic. After three straight months of outflows, emerging market (EM) equity funds tracked by EPFR Global attracted more than $700 million of investments in the first two weeks of July.

In its recent quarterly equity outlook, HSBC’s strategy team also reiterated its preference for stocks in emerging markets over developed regions for the next six months.

“The tentative move back into EM could be in anticipation of a rebound in the economic data, which disappointed [in the first half],” HSBC’s analysts wrote. “And this is something we would not disagree with.”

While central banks in the developed world have virtually no room to cut interest rates further to support growth, emerging market central banks have scope to act aggressively, investors argue. Many major central banks have already started to cut rates to buttress their economies, led by China and Brazil.

“The monetary authorities [in emerging markets] still have considerable scope to reflate their economies,” says Ewen Cameron Watt, chief investment strategist at BlackRock Investment Institute and chairman of the asset manager’s central strategy group.

BlackRock forecasts that earnings per share in emerging markets will stay steady at 9.3 percent year-on-year this year, outpacing the 8.9 percent earnings per share growth of developed markets.

Coupled with the fact that emerging markets trade at a 20 percent discount to developed markets, this could be a “launching pad for outperformance”, the world’s largest fund manager says in its updated 2012 outlook, released earlier this week.

The disappointing performance in the first half of the year was caused by short-term jitters, argues Antoine Colonna, head of consumer research at Carmignac Gestion, a French asset manager. Growth in China may be slowing but same store sales in Chinese companies are still doubling year-on-year, according to Mr Colonna.

Indeed, stocks of consumer companies remain one of the favourite EM investments in the coming months. Fund managers and strategists argue that the growing middle class in Asia and Latin America could be one of the biggest drivers of the global economy – and stock market returns – for the foreseeable future.

By contrast, companies in more cyclical industries such as commodities, financial services and real estate are viewed with scepticism. These sectors were the main drag on the performance of emerging markets in the first half of the year, and few expect them to turn round in the latter half of 2012.

Underlining the tentative improvement in sentiment, Société Générale’s monthly investor survey showed rising optimism towards global EM stocks.

The percentage of investors polled that had a bullish near-term outlook on emerging markets rose to 49 percent in July, from 38 percent the previous month. The percentage of investors bearish towards developing markets fell 20 percentage points to just 27 percent.

Yet many investors and analysts are unconvinced, pointing out the tenuous links between economic growth and stock market returns. As Robert Buckland, chief global equity strategist at Citigroup, said in a recent note: “Emerging market companies have struggled to turn premium [economic] growth into premium earnings-per-share-growth and we don’t see this changing soon.”

Although bearish investors and analysts concede that developing world central banks have scope to cut rates, they fear this is more a sign of impending weakness identified by the authorities than strength.

In its most recent World Economic Outlook, the International Monetary Fund cut its forecast for EM growth to 5.6 percent for 2012 and 5.9 percent for 2013, down 0.1 and 0.2 percentage points respectively on previous predictions.

“Emerging markets are still more dependent on global growth than vice versa,” says David Jacob, chief investment officer of Henderson Global Investors. “The long-term story is good, but in the near term things look very different.”

Allan Conway, head of EM equities at Schroders, argues that emerging markets are set for “significant outperformance” relative to developed markets, but concedes that the latter’s woes are weighing on their outlook.

“If the world consisted just of emerging market economies, and didn’t include submerging economies, we’d be looking for 40-50 percent returns on emerging markets [this year],” he says.