Will 2016 be the sixth year of emerging-market underperformance?

Andy Brunner | 19 Jan / 2016

Andy Brunner is head of investment strategy with Morningstar UK.

2015 was another very difficult year for emerging-market economies, and currencies have naturally been reflected in generally poorly performing equity markets. Indeed, emerging markets have underperformed developed markets by around 14 per cent in dollar terms and for the fifth consecutive year.

From the peak in October 2010, emerging markets have now declined by nearly 50 per cent compared to developed markets. Emerging markets remain a challenging call principally because of ongoing macro headwinds that suggest little growth improvement for 2016.

US Federal Reserve interest-rate rises, a stronger dollar, the likelihood of even lower commodity prices and China's slowing growth combine with a debt overhang problem that could create further stress as interest costs increase and credit conditions tighten.

There is still scope, therefore, for downside surprises to growth, debt and currencies, hardly the ideal background for equities. Hence, despite the asset class being cheaply rated, many investors will be reluctant to return until signs of a growth reversal become apparent.

With commodity prices remaining lower for longer, the effects will continue to be felt in many countries through 2016 and, in particular, developments in Brazil are of growing concern.

In contrast, activity in Asia appears to have stabilised but medium-term structural headwinds persist with new growth drivers required as the manufacturing export-led model becomes increasingly deficient.

Despite these medium- to long-term impediments, and perhaps partly because of the markedly negative sentiment towards emerging markets, there is growing interest in emerging markets from contrarian and value investors, many of whom believe some of the needed adjustment has already occurred.

In some ways, much of this background is effectively noise, as the key question for emerging-market indices is: What is the outlook for Chinese equities?

Through outperformance and the recent addition of US-listed ADRs, China's weighting in the MSCI Emerging Markets Index will rise to around 26 per cent compared to less than 20 per cent a year ago and could increase further on a decision by MSCI to include China "A" shares at a later date.

The next three largest countries in the index are all in emerging Asia, which now accounts for well over 70 per cent of the total.

Four years ago, Brazil was battling for top spot but its weight has collapsed to about 6 per cent, while that of Russia is only around 3.5 per cent.

The importance of both in the emerging-markets index is now effectively relegated to potential contagion effects rather than absolute performance.

With economic and profits growth in Asia in relatively short supply, the Fed tightening and China slowing, there is little reason to expect any significant revaluation and expectations of mid-single-digit EPS pass as a best estimate for gains in emerging Asia.

As ever, there is substantial scope at the stock level and with significant individual opportunities in countries such as Indonesia, the Philippines and Thailand, all of which, however, are less than 2.5 per cent of the emerging-markets index.

Even so, it is interesting to note that both Credit Suisse and Barclays strategists have moved emerging markets to overweight recently while others, such as Goldman Sachs, see growth improvement as a late second-half story and expect most emerging markets to bottom in the first half of next year.

Morningstar, Inc.