Five Factors for Emerging Markets

All equity markets are currently experiencing a phase of higher volatility. On the one hand, this a natural consequence of the fact that the US stock market in particular displayed much less volatility last year compared to its historical average. On the other hand, the rise in commodity prices and the strong US economy are increasing inflationary risks. Higher-trending commodity prices and a stronger global economy are both positive and negative phenomena. Bonds, particularly those of Western industrialized nations, tend to be less interesting than equities in such a market environment – and less appealing than emerging market equities in particular, as we show here.

Rising commodity prices
Past experience shows that in an environment (like today's) of rising commodity prices, emerging market equities often outperform the other equities. This is unsurprising given that commodity equities are highly weighted in the emerging markets – more than 25% in Latin America, for example. At the same time, higher commodity prices tend to go hand in hand with a weaker US dollar, as we are seeing right now. Moreover, since 2016 rising commodity prices has been accompanied by a steady improvement in the return on equity and profitability of emerging market companies.

Emerging market currencies continue to look cheap in historical terms
Secondly, emerging market currencies remain historically cheap, currently languishing some 20% below their average level since 2000. Given the improvement in the key fundamentals, they offer considerable potential for a higher valuation. For example, external debt of many emerging market nations has declined as a percentage of GDP, which makes crises such as that of 1997/98 less likely. Moreover, the current account balance of many countries has improved, as evidenced by Russia's surplus and Brazil's recovery.

Strong economic growth in emerging markets
The leading indicators of key countries such as Brazil, China, Russia and Taiwan are currently enjoying an up - ward trend. At the same time, however, there are still no indications of any overheating, which is why the majority of central banks stay accomodative. Whereas in the first decade of the new millennium the economic growth of the emerging markets outstripped that of the old industrialized nations – leading to clear outperformance on the part of emerging market equities – growth then slowed over the period 2010-2015, with a resulting underperformance of these equities. Since 2016 the pendulum has swung back in favour of the emerging markets, with growth strengthening relative to other countries – and with further upside potential going forward.

Emerging market equities: price/earnings valuation is 20% cheaper than world equity index (MSCI World)

Emerging market equities still relatively cheap in historical terms
It is not just emerging market currencies but also the equities of these countries that continue to have relatively low valuations historically. When measured in terms of both price/earnings ratios and price/book ratios, emerging market equities are trading at a discount of some 20% to the world equity index (MSCI World). Obviously there are risks involved, as is always the case when investing in equities – in the absence of any risk, the long-term returns on equities would be lower than those on bonds, which as we know is not the case. As is true generally for equities as an asset class, the risks of emerging market equities include a dramatic economic slowdown in China, a very strong US dollar, an escalating trade war, or a renewed collapse in commodity prices, which currently is not our main scenario.

Interesting technology sector sees structural increase in weighting
But something else of importance has also changed in the emerging markets over the last 18 months, without attracting much coverage in media headlines: The weighting of the technology sector has increased sharply. The technology sector is enjoying a phase of strong global demand at the moment, as international companies seek out products that can improve productivity. Accordingly, investors interested in structural, longer-term growth driven by the restructuring of the global economy have inevitably been drawn to the products of Asian technology companies in particular, which in turn supports their shares. The positive result is that the sought-after technology sector now boasts a weighting of some 20% in the emerging markets, a figure that rises to as much as 30% or so in Asian emerging market equities.

Conclusion
To summarize once again the five factors in favour of emerging market equities: Rising commodity prices, historically attractive currency valuations, good economic growth, a stronger weighting in the globally important technology sector and relatively low equity market valuations compared to the world equity index all make emer ging market equities look interesting. A corresponding focus module is available for an investment in this area.

This publication is not intended to bring about the conclusion of a contract, but solely provides market and investment commentary by Maerki Baumann & Co. AG and an assessment of selected financial instruments. Hence, this publication does not constitute investment advice or an offer to buy or sell investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. Maerki Baumann & Co. AG accepts no liability whatsoever for the contents of this publication. In particular, it does not accept any liability for losses or damage of any kind, whether direct, indirect or incidental, incurred as a result of using the information contained in this publication and/or arising from the risks inherent in the financial markets.

Editorial deadline: 9 March 2018

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