Conditions across emerging markets (EM) have improved markedly since the early months of 2016, when the Federal Reserve (Fed) determined to slow its efforts to normalize rates and China announced a “mini stimulus” in an effort to balance reforms with growth. Mild stimulus helped to stabilize demand, but immediate relief came from much improved financial conditions. Deservedly, valuations bounced from extreme lows, but for the rally to continue, it will be increasingly important for earnings to meet expectations.

Expectations have diverged significantly across regions mainly as a function of implied profit margin expansion1 in Latin America (LatAm) and EMEA in anticipation of better growth ahead, while Asia is mainly a story of earnings normalization. In this article, we examine the relative risks in achieving these assumptions, specifically focusing on growth dynamics against still high levels of corporate debt and servicing costs.

Two phase decline and the current recovery

The history of forward earnings provides a useful starting point for distinguishing the different drivers of the downturn and potential sources of earnings improvement as headwinds turn to tailwinds. Chart 1 shows forward earnings estimates for each region compared to the dollar (inverted), which serves as a proxy for financial and liquidity conditions. The yellow area shows gradual tightening marked by slowing demand growth and falling commodity prices, while the red area defines the period of aggressive tightening as the Fed prepared to and eventually did lift rates in late 2015. The green area is the current period of easing financial conditions with the Fed on hold, and thus helping to stimulate stabilize demand.

Chart 1: Forward 12-Month earnings (local currency, rebased to Sep 2006=100)

Chart 1: Forward 12-Month earnings (local currency, rebased to Sep 2006=100)

Source: Bloomberg as of October 20, 2016

As a commodity exporter, LatAm suffered the most in the tightening period, with forward earnings declining since 2011. In contrast, falling commodity prices provided a tailwind to Asia, a region that is also benefiting from ongoing reforms. Estimates only began to decline late in the aggressive tightening cycle when China devalued its currency, spreading a growth scare across the region. EMEA consists of a mix of commodity exporters and importers with earnings downgrades mainly occurred throughout the aggressive tightening phase impacted by commodity declines combined with pockets of funding stress.

As financial conditions began to ease in early 2016, LatAm and EMEA have both experienced significant upgrades in earnings expectations, often associated with a return to an upcycle. Given the commodity rebound from multi-decade lows, coupled with returning flows and liquidity, the rebound seems justified, but with continually tepid global demand and high levels of corporate debt servicing cost, the trajectory of the recovery is uncertain. For Asia, forward earnings estimates have stabilized with such now basically recovering the earnings lost previously, as conditions normalize.

Divergence of expectations versus reporting earnings

To date, reported earnings across all three regions have stabilized but have yet to meaningfully turn upward, implying a meaningful divergence from expectations in LatAm and EMEA. Looking behind earnings estimates to their component parts — expected sales growth and implied profit margin expansion – the latter is the main driver of this divergence.

Chart 2 shows reported profit margins, with the implied profit margin expansion shown to the right of the blue line. Implied margin expansion is essentially reversing a portion of the previous compression, with LatAm suffering the worst prior declines and, therefore, implying the strongest recovery, followed by EMEA. Asia profit margins were basically unaffected by the downturn, with implied margin expansion remaining modest, only expected to rise from 8.3% to 8.5%.

Chart 2: Reported profit margins versus implied expansion

Chart 2: Reported profit margins versus implied expansion

Source: Bloomberg as of October 20, 2016

Improving fundamentals help to fill part of the expectation gap

For LatAm and EMEA, profit margins can improve considerably on the back of an economic recovery, partly driven by the removal of one-off expenses associated with the downturn (e.g. restructuring, write-offs, etc). Moreover, the outcome of these one-off costs has produced leaner, more profitable companies.

Downturns in LatAm and EMEA were exacerbated with deteriorating fiscal accounts coupled with rising political risks. Stabilizing demand and commodity prices offered a significant lift to confidence, further boosted in LatAm with improving political dynamics — mainly in Brazil with a shift in leadership bringing a reform agenda to contain the otherwise unsustainable fiscal deficit.

These elements together suggest a much improved outlook, but it is important to take stock of headwinds that could slow the trajectory of improvement — the largest being high levels of debt that impede growth and continued high debt servicing costs that continue to add pressure on profit margins.

High levels of debt and servicing costs to weigh on margin expansion

Since 2007, just prior to the financial crisis, corporate debt levels have steadily risen across and all three regions. As shown in Chart 3, debt levels are highest in Asia, with credit expansion mainly driven by China. However, the cost of debt service is quite different across the three regions – both as a function of the direction of interest rates and the proportion of dollar denominated debt, both impacting debt servicing costs.

Chart 3: Nonfinancial Corporate Debt

Chart 3: Nonfinancial Corporate Debt

Source: BIS, October 2016

Interest rates implications

LatAm and EMEA both experienced about a 50% currency adjustment since 2011, which caused high levels of inflation. While Asia experienced a 13% currency adjustment, the pass through was more than offset by deflationary forces, including lower commodity prices, which pushed inflation to record lows. As shown in Chart 4, rising inflation brought higher interest rates both in LatAm and EMEA since 2013, whereas rates in Asia have been in steady decline.

Chart 4: Regional interest rates (MSCI EM weighted)

Chart 4: Regional interest rates (MSCI EM weighted)

Source: Bloomberg as of October 20, 2016

Inflation peaked in EMEA several months ago allowing for rate cuts, while inflation is seems to be peaking in LatAm, allowing for possible rate cuts. Corporate profit margins should improve as interest rates decline, but cost savings will take time. Meanwhile, in Asia, interest rate declines have helped to keep profit margins steady despite rising levels of debt.

Continued high costs of USD denominated debt

In LatAm and EMEA, USD-denominated debt has effectively doubled with the halving of the two currency blocs. As shown in Chart 5, this debt is particularly acute among commodity exporters which, by their heavy weighting in the regional equity indices, has impacted LatAm badly, while less so in EMEA.

Chart 5: USD Portion of Non-Financial Corporate Debt

Chart 5: USD Portion of Non-Financial Corporate Debt

Source: BIS as of October 2016

Asia was also negatively impacted by this currency mismatch, but with the impact being more on the macro-economic side via a liquidity squeeze.

The Asia Squeeze

The downturn in Asian profits was primarily driven by weak demand in China, driven by an ambitious reform agenda that impeded economic growth, coupled with tight conditions caused by its peg to the strong USD. The catalyst for earnings downgrades came in August 2015 when China devalued its currency by 3% as a policy step to de-link from the USD. Though aligned with its reform agenda, the move triggered fears of a deeper slowdown accompanied with a surge in capital outflows, inflicting a tight liquidity squeeze across the region.

Capital outflows can take different forms, but the unwind of the so-called “carry trade” (paying down USD denominated debt) was clearly a significant contributor to the large outflows that accelerated through the early part of this year. It is difficult to estimate the degree of speculative unwind, but given that capital outflows have slowed to manageable levels despite continued depreciation of the Chinese Renminbi — now down nearly 8% from just before the devaluation — suggests that much of the speculative unwind is complete.

Importantly, devaluation of the currency both relative to the USD and its trade basket helped to reverse most of the tightening inflicted by the aggressive USD rally. Also, China shifted its policy focus to a balance between reforms and growth. Of course, China walks a fine line given already very high levels of debt, but so far high savings rates and confidence in the system has kept the system functioning, as reforms continue to push the economy toward a more sustainable balance.

With negative conditions of the squeeze in Asia having largely been removed, liquidity and economic demand conditions are normalizing, with the still-important tailwinds of low commodity prices and a strong reform agenda that continues to gather pace across the region. Indeed, consensus earnings are forecast to grow 16% over the next year, retracing about three quarters of the earnings decline.

Market pricing of forward earnings

Meeting earnings expectations will be important, but even more so for those markets paying a premium on forward earnings (forward price to earnings) compared to historical averages. As shown in Chart 6, the forward PE is up across the board with all three regions currently priced at a premium, but to varying degrees. LatAm is pricing with the highest premium (+19%), followed by EMEA (+12.5%) and Asia (+6.6%).

Chart 6: Forward Price to Earnings (Forward PE)

Chart 6: Forward Price to Earnings (Forward PE)

Source: Bloomberg as of October 20, 2016

Conclusion

The dynamics of the earnings recovery across the three regions of EM differ widely. For LatAm and EMEA, the recoveries are from a much deeper downturn and are experiencing significant upgrades, as commodities and financial conditions have stabilized earlier this year.

Reported earnings have yet to turn upward, meaning that earnings will need to rise aggressively to keep up with market expectations — particularly in LatAm and EMEA. The key challenge is the high level of corporate debt, with high debt-servicing costs adding pressure on profit margins against forecasts that imply considerable expansion. If earnings fall short of delivery, forecast downgrades are likely to add pressure to these markets, particularly as their forward earnings are being priced at a fairly high premium compared to historical averages.

The earnings recovery in Asia is quite different from Latam and EMEA, with earnings simply expected to retrace most of the losses incurred by last year's liquidity squeeze and weak economic demand, as the conditions for such have been mainly removed. Also, the market trades at a small premium to forward expectations, but the path of recovery is not overly ambitious and is more tangibly achievable.

Footnotes

  1. Analysts do not specifically forecast profit margins, but profit margin expansion is implied as making up the difference between expected sales growth versus earnings growth