EM equities have run ahead of fundamentals and earnings are likely to disappoint materially again, as has been the case in recent quarters, notes Morgan Stanley.

Andrew Sheets and team at Morgan Stanley in their April 30, 2015 research report titled: “Cross-Asset Brief – Buy EM Vol into Earnings” notes market expectations of the EM earnings season are at elevated levels.

Persistent weakness in EM earnings

The Morgan Stanley analysts note after lagging the last quarter of 2014, EM equities have rallied sharply, recovering more than half the underperformance since 3Q14. The biggest contribution to the rally has come from China thanks to its policy easing. The EM rebound was also aided by a dollar pause after an intense rally. However, MSCI EM and APxJ earnings have missed nine out of the last eleven quarters:

EM retraced half its underperformance EM Equities

Sheets and team point out that EM earnings have been persistently weak for several quarters now, with 3Q and 4Q witnessing significant misses. Morgan Stanley’s EM strategies forecast for EM 2015 EPS is as much as 400bp lower than the current consensus expectations.

The analysts note China and India are the biggest contributors to EM returns in the last year, though they face near-term challenges. However, as can be deduced from the following chart, EM implied volatilities have been trading near historical lows, relative to developed market equities:

Low EM volatility EM Equities

Depressing implied vols in EM equities

The Morgan Stanley analysts note within the EM complex, volatilities for “China-correlated” indices have risen in the last month or so, reflecting the sharp rallies in these markets. As set forth in the following table, implied vols of India and Brazil are still at the low end of the last year’s range:

Volatility dashboard EM Equities

Andrew Sheets et al points out that skews are flat, and term structure 3m-1yr is very negative.

The Morgan Stanley team highlights that EM hedges are attractive either on an outright basis or versus DM equity vols. They note KOSPI hedges are attractively priced, as KOSPI has the lowest ATM implied vol among the major indices except S&P 500.

Elaborating further on hedges, the analysts note Nifty hedges are also underpriced, with implied vol is close to 5-year lows and only slightly above realized volatility.

Low implied volatility of Nifty EM Equities

The analysts note that in contrast to the inexpensive vols in EM, Nikkei vol looks too rich, as it stayed elevated from 2013-15 even as EM vols declined steadily.

Nikkei vol too rich EM Equities

Therefore, Sheets and colleagues suggest hedges on the KOSPI and Nifty, as well as buying vol in these indices against selling vol in Nikkei.