Investors feel anxious about the sustainability of the emerging market equity rally in the first two months of 2017. Dollar strength, key limiter of emerging market equities performance, is still uncertain under the pace of Trump’s policy implementation. Will EM outperform again this year? Probably yes. We still see some factors supporting EM performance.
EM profit margin has further to go
Last year, EM return contribution from ROE was positive for the first time since 2011. Based on the Credit Suisse estimation, non-financial net profit margins expand 6% by using a DuPont analysis, also the first time since 2010. We believe the recovery in EM profit margins has further to go. First of all, EM energy and materials sectors can benefit from a lower base of 2016. The index representation of the two sectorstotal around 15% of MSCI EM index, while the longer-term averages are even over 25%. Secondly, EM industrial production growth is in an expansion cycle. It is also driven by strong base effects in the recovery in Brazil and Russia. Lastly, profit margins are subject to expansion as growth in productivity outpaces wage growth, which means local currency unit labor costs are now declining.
Led by a seven-year consolidation in resource sector capex discipline, the capex to sales ratio has declined. Moreover, EM also has discipline to control the debt ratio, which leads to a heathy growth mode. Two factors will help profit margin has further to go.
EM currencies remain cheap
EM currencies are significantly discounted (50%) versus the 20-year average level. Although some investors may question the dollar strength lead to week EM currencies, we believe the risk was less than the past five years. Instead of representing a flight to safety assets, the dollar strength represents a stronger US economic growth prospect. EM equities remain a play on US industrial productiongrowth, unless a significant change in US trade policies.
Relative valuation offer an attractive entry point
EM equities are trading on a forward P/E of 12x, in line with 20-year average, but with 27% discount relative to DM. On the other hand, global equity funds retain substantially underweighted in EM. However, they are accumulating EM assets since last year. Based on EPFR data, global fund managers still underweight EM by 3.6%, compared to the benchmark.