Amid all the hysteria about the potential headwinds that the election of Donald Trump as US president will create for emerging markets, I remain resolutely optimistic about their prospects. Up to the election on 8 November, emerging markets had undergone a remarkable recovery from a low point in January – delivering their best performance since 2010 – and I am optimistic for further gains, particularly from value-orientated stocks.
The rally this year was driven by gains in out-of-favour, and therefore cheaper, markets such as Brazil, which alone accounts for about a third of the overall performance of the MSCI Emerging Markets Index year-to-date. The more crowded, and therefore expensive, markets are the laggards with India and Mexico notable underperformers. Similarly, at a sector level the cheapest sectors have led the charge. Does this all point towards a rotation to ‘value’ stocks?
Looking back through time (as shown in the following chart) you can see that from a style perspective value tends to outperform ‘growth’ in emerging markets. Over the past 20 years, growth has tended to only outperform value for short periods. These have usually coincided with an emerging market ‘crisis’ such as the Mexican debt crisis and the Asian crisis in the late 1990s.
Since 2010 though, we have lived through the longest ever growth market, despite there being no notable ‘crisis’ to speak of. In a volatile period with faltering global growth, investors sought out those companies with growth potential and/or stable, more predictable earnings streams.The length and magnitude of this growth market has left the valuations of growth stocks looking incredibly high relative to their value peers.
(Bernstein generates growth scores based on revenue growth, valuations, dividend payout and profitability. Bernstein classifies stocks among the highest third of growth scores in a region as “growth” and those among the lowest third “value”.)
Over the course of 2016, there’s been a modest shift from growth to value. This only goes a small way to reversing the trend of recent years and the potential rewards from investing in value stocks could be significant.
There are three key reasons why the valuation gap could potentially close. First, the discount of value stocks is simply too great; second, earnings for value/cyclical companies are improving driven by the financials and materials sectors; and third, the factors that originally encouraged investors to favour growth stocks are starting to weaken. Rising rates in the US will hurt ‘bond proxy’ trades and reduce the appeal of income-generating stocks. Furthermore, with an improving outlook for the global economy the ‘growth-scarcity’ premium will be reduced.
Looking at valuations across emerging market sectors, the universe is extremely polarised. Today, investors are being paid to take a degree of cyclical risk and accordingly I am finding more opportunities in sectors such as financials and technology. Investors have paid up for companies with more predictable earnings streams, to the extent that the more defensive sectors such as consumer staples and healthcare are trading on very high multiples. These areas which are perceived to be safe are so expensive that they could now be considered risky.
Despite the potential headwinds that a Trump presidency will create for emerging markets, I am optimistic about their prospects. Emerging markets generally benefit from an upturn in global economic activity and that a rise in US interest rates – in response to robust growth – is not the risk it is perceived to be. The impact of a stronger dollar on emerging markets is also causing some concern – given the widespread awareness of the historical inverse relationship between the two – but emerging market valuations are already pricing this in.
However, it remains essential to be selective. In today’s markets, the most rewarding approach is to be value-oriented and contrarian.