Emerging market (EM) equities have had a great run recently. But don’t buy EM stocks indiscriminately. Focus on company earnings over macroeconomic trends to find stocks that have stronger return potential with reduced risk.

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The MSCI Emerging Markets Index has surged nearly 42% in just 21 months. That’s almost double the performance of the MSCI World Index of developed market stocks. After several tough years, EM are finally living up to expectations and unleashing powerful pent-up return potential.

What’s behind the strong momentum? It’s really all about earnings, and less about macroeconomics. In fact, contrary to conventional wisdom, the correlation between GDP growth and stock performance in EM is close to zero. On the other hand, the relationship between earnings and stock price is much more closely linked (Display).

Emerging Equity Stars

That makes sense. Equity investors are ultimately investing in companies, not countries. And at the moment, the earnings outlook for companies in the developing world is robust, with consensus expectations projecting a 30% increase over the next two years.

Pay attention to earnings expectations

Changes in expectations are even more important, especially if stock prices already reflect a rosy outlook for earnings. Shifting expectations explain why EM returns were lackluster for several years and then strong more recently, as indicated by the recent rebound of earnings revisions (Display, left).

Key in on standout industries

Which sectors drove the rebound? The technology and materials sectors have been the biggest contributors to EM earnings since the beginning of 2016 (Display above, right). Financials and consumer staples improved more modestly, while the upticks in the utilities and telecom sectors have been more muted.

Rising optimism about EM technology, commodities and financials sectors is justified, in our view. Chinese e-commerce companies are doing an outstanding job and are even out-innovating Western peers in some cases. In commodities, prices are stabilizing amid improvements in global demand and a Chinese government crackdown on environmentally unfriendly capacity. For banks, interest-rate stabilization and fewer bad loans bodes well. We expect these trends to broadly persist.

However, the earnings outlook is less dazzling in other industries. Four of the five largest EM telecom companies are facing earnings pressure due to increased competition. In the utility sector, regulated utilities have seen little earnings growth.

Stay focused on companies

That’s why individual stock selection is key even when the broad outlook remains strong. For example, container-board companies in China are benefiting from insatiable demand for boxes for e-commerce. That demand has influenced rising earnings expectations much more than the broader economy. In central Europe, banks have generally moved beyond the trauma of the foreign-currency mortgage crisis. With strong loan books, select lenders are well capitalized and positioned to benefit from any potential rate rise.

India presents a complex dilemma for stock pickers. While the long-term future of India’s economy is exciting and several companies are poised to capitalize on long-term growth trends, some sectors are coping with big challenges. Pharmaceutical companies are struggling with growing price pressure, leading to downward earnings revisions. The IT sector has experienced slower growth and margin compression.

When we look at a heat map of the EM universe, there aren’t many countries or industries that are uniformly strong or weak; we see divergent tends across the board.

Beware of lurking risk

Challenges to companies’ business outlooks reinforce the need for a risk-aware approach. While the volatility of the MSCI Emerging Markets Index has declined by about 35% in 2017, don’t be lulled into a false sense of security. When you look at individual companies, about 10% of index constituents have experienced a surge in volatility of more than 30% this year. Even in a broadly stable environment, there are always pockets of uncertainty to avoid.

Market volatility is always a palpable risk in EM. Investors could get scared away by many potential issues, from the reversal of extremely loose central bank policies to escalating tensions in the Korean peninsula. To be a successful EM investor, it’s critical to protect when the inevitable sell-offs occur.

Investors in EM stocks must stay aware of potential pullbacks. Even amid strengthening earnings and attractive valuations, threats to individual stocks and market stability cannot be ignored. Focusing on the fundamentals of individual companies, with careful stock selection that emphasizes downside protection, can help investors navigate the next stage of the EM recovery.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Article by by Sammy Suzuki – Alliance Bernstein