A March 24th report from Goldman Sachs Portfolio Strategy Research focuses on emerging markets, and argues that most emerging markets are facing the dual headwinds of slow growth and high interest rates, which is likely to keep pressure on both earnings and valuations, in a report titled ” What happened to the EM growth story?”.
GS analysts Caesar Maasry and Jane Wei explain their perspective: “Unlike in DM [developed markets], where growth prospects are broadly improving and low rates appear supportive of above-average valuation levels, EM is faced with slowing growth and high interest rates relative to equity yields. We maintain that until EM EPS prospects improve (2014 marked the lowest EPS since ‘09), MSCI EM will remain an aggregate underperformer vs. DM.”
More on weakness in emerging markets
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Maasry and Wei argue that “growth explains both absolute and relative returns of EM equity.” First, they highlight that valuation (that is, EM stock’ apparent ‘cheapness’) has not been a “useful metric for assessing subsequent returns.” They note that investors were more worried about potential capital outflows from EMs, likely related to the strong U.S. dollar and a looming increase in U.S. rates.
The GS report also notes that that things appear less than sanguine in terms of of EM corporate fundamentals. The MSCI EM is almost the exact level as it was in December 31, 2009. Also of note, aggregate EM EPS has not grown since 2010. Maasry and Wei Note: “Our core view holds that MSCI EM will trade sideways this year (in USD), likely rising through 2Q on disinflation and then stumbling in 3Q as the Fed hikes rates and consensus EM EPS estimates are cut.”
It really boils down to the fact that DM earnings are rising, and EM earnings have stalled. The GS analysts point out that the strongest indicator of the EM cycle is the relative growth profile between EM and DM. Note that most analysts have upped their index targets for Europe and Japan based on underlying strength in earnings trends.
Exhibit 2 makes it clear that earnings have been consistently strong in the U.S. since the end of 2008, strong in Japan since late 2012, and now may start to improve in Europe after several years of weakness. EPS recovered notably in 2009 and 2010 for EM, but has gone nowhere since since as have equity returns.
No EM recovery until 2016
Maasry and Wei note that although EM GDP growth typically exceed that of DM, EM earnings growth often lags. They point to “long-term studies of EM that suggest that growth ‘delta’ is the chief indicator of EM cyclical turns; here we note that the actual level of EPS growth in EM can dip below DM (GDP growth, however, has always been greater in EM than in DM over the past few decades).”
Based on five-year historical earnings CAGRs, emerging markets earnings growth has generally exceeded that of DM (using the S&P 500 as a DM proxy). There have been exceptions, such as the early 1980s (Fed tightening and U.S. recession), the late 1990s (Asia financial crisis) and the last four years.
The GS analysts explain why they differ from the consensus view: “A further five years of sub-DM growth, as consensus expects, would be an historical anomaly; and this in part anchors our view that EM growth should recover, though not before 2016 due to the cyclical headwinds we discuss below.”