Emerging markets (EMs) have underperformed developed countries since 2011 with disappointing earnings followed by valuation de-rating due to diminishing growth prospects. The difficulty for EM has been finding growth. Since 2011, after the post-crisis surge to rebuild inventories and the splurge in China credit, global trade has continued to disappoint. The transition from an export model to local demand has been a slow process but, importantly, progress is being made. Still, the EM outlook varies quite significantly, most notably for the relative impact of declining commodity prices and the different degrees of progress in effecting pro-growth reforms. We see interesting opportunities in Asia versus EMEA and LATAM but, overall, EM is likely to continue to struggle given weakness in commodities and high sensitivity to the US tightening cycle.

Simple valuation comparisons suggest to some that it might be time to lean in favour EM over developed market, but closer inspection reveals a more mixed outlook. EM fundamentals tend to be similar by region, and therefore regional analysis is instructive for understanding valuations in the context of local macro dynamics as a framework for looking forward. On balance, valuations are reasonable, but macro headwinds are likely to weigh on earnings growth prospects for many. Declining energy prices and reforms are broadly positive, while weak commodities, dollar strength and eventual US rate hikes will be a headwind for many.

The Asia EM analysis shown below includes time series for a number of valuation metrics1at the top with two momentum series2 shown at the bottom. The valuation graphs compare various valuation metrics to their historical average where shades of green reflect inexpensive valuations and red reflects expensive. Valuation is the single most important driver of return, and therefore green represents value opportunities while red shows reason to be cautious. The chart contains large amounts of data, but one can gain a general sense of current valuations by the overall greenness or redness on the right side of the charts.

Referring to the Asia chart, valuations have been relatively inexpensive since late 2011, while return on equity has declined, which is consistent with weaker demand due to slower trade growth. Still, price momentum has remained moderately positive, supported by some earnings growth with improving fundamentals. Overall, Asia is experiencing a stronger mix of tailwinds than its regional peers, though there are headwinds to consider.

Tailwinds include declining oil prices, which is a strong positive for improving the terms of trade, fiscal budgets and local consumption. Across the region, Asia has also made notable reform progress. The new government in China has made important reforms to curtail corruption while introducing safety nets to reduce the need for individual savings for future spending, like retirement, thus allowing for higher current consumption. After the so-called “taper tantrum”, India and Indonesia implemented significant and important reforms to rebalance their economies for stronger internal growth and less external dependence.

The headwinds for Asia are deflationary pressures from a fast declining Japanese Yen and a surging dollar. Because many EMs are either pegged to the dollar or maintain a “dirty float”, the strengthening dollar acts as an effective tightening policy factor.

Asia EM: 28 November 2014 / Valuation (+)/ Momentum (+)

Asia EM: 28 November 2014 / Valuation (+)/ Momentum (+)

Source: Bloomberg / Nikko Asset Management

EMEA appears attractive from a valuation perspective, except the return on equity remains at relatively depressed levels. Most of this downturn is a reflection of the shock to Russia from sanctions, heightened political risk and the decline in oil price. While it might be tempting to call a bottom at these extremes, the outlook remains highly uncertain – particularly given the recent sharp declines in the oil price. Momentum remains slightly positive, mainly due to the relief rally (after the large sell off in 2013) across the rest of EMEA in reaction to declining interest rates.

Outside Russia, the balance of EMEA has other headwinds with which to contend – mainly structural imbalances such as in Turkey and South Africa, which depend on foreign funding. Unfortunately, funding these imbalances is likely to become more difficult next year both due to the stronger dollar and eventually higher US rates.

EMEA EM: 28 November 2014 / Valuation (N)/ Momentum (+)

EMEA EM: 28 November 2014 / Valuation (N)/ Momentum (+)

Source: Bloomberg / Nikko Asset Management

Latin America’s large export concentration in commodities remains a strong headwind for the region. Despite poor performance, its equities are not yet cheap because of the degree of earnings decline, and it remains difficult to see a catalyst to the upside, as the strong dollar may continue to weigh on commodity prices. There are pockets of strong reform, such as in Mexico, which is encouraging, but more reform is needed elsewhere to broaden the economic rebalance.

LatAm EM: 28 November 2014 / Valuation (-)/ Momentum (N)

LatAm EM: 28 November 2014 / Valuation (-)/ Momentum (N)

Source: Bloomberg / Nikko Asset Management

Regional analysis helps to distinguish opportunities from risks, and while there are reasonably priced growth opportunities mainly in Asia, headwinds probably outweigh tailwinds for EM as a whole. Further easing outside the US, such as in Japan and Europe, will help to offset declines in liquidity, but it is unlikely to fully offset the tightening effects driven by US policy. Still, the decline in energy prices is likely to be is significant tailwind outside of energy exporters, and declining inflation is a positive for some to allow for policy easing. Most importantly, reform is gathering pace, mainly in Asia for the moment, to support long term secular growth driven increasingly by internal demand. Ultimately, these reforms coupled with strong balance sheets and demographics will support higher levels of global growth for decades to come.

1The valuation metrics shown are: CAPE (Inverse) – cyclically adjusted earnings yield; PER – Price to Earnings Ratio; PBR – Price to Book Ratio; PSR – Price to Sales Ratio; ROE – Return on Equity.
2The momentum factors shown are: 12M Mom – 12 month performance; MACD – Monthly MACD