UBS: Is it too late to buy into the emerging market rally?

Emerging markets (EM) have outperformed sharply so far in 2016. The Brazilian real, Russian ruble, and South African rand have topped the global rankings versus the US dollar. And the MSCI Emerging Market Index has risen more than twice as fast as the S&P 500, leaving EM stocks trading at trailing price/earnings ratios above their 10-year average. Investors might be wondering if this boat has sailed. 

But looked at over the past five years, the picture looks very different. Both currencies and stocks still have a lot of catching up to do after a long malaise. On a real effective exchange rate basis, EMEA and Latin American currencies are still sharply lower, and the MSCI EM is down by 23% – compared to a rise of 68% in the S&P 500. Currencies did as expected during a period of economic weakness, depreciating to restore competitiveness. 

We believe EM equities and currencies remain attractive, at least on a relative basis.

1. The macro recovery of EM appears to be gaining strength. This time the boost to growth is not just coming from stimulus in China. Brazil and Russia have been turning too. On aggregate, the manufacturing purchasing managers’ indices for EM rose to 50.7 last month, above the 50 level that separates expansion from contraction. The fact that the recovery is broad based makes it look sustainable.

2. This seems to be feeding through into earnings. The earnings revision ratio, which measures analyst upgrades versus downgrades, was at –40% in February, indicating far more downgrades. Now it is close to zero, pointing to a marked improvement in sentiment. This has been a reliable indicator of future returns. The actual earnings have stabilized too. The revival of energy and materials prices is contributing to this rebound.

3. A shortage of alternatives is also a positive. Net inflows into EM are set to be positive for the first year since 2012, according to EPFR data. Revealingly, 90% of the inflows have come after the Brexit vote. With Europe under stress, leading emerging nations seem less troubled by comparison. 

Fed hikes can be damaging to EM, sucking out capital as risk-free US rates rise. But higher US rates have not proved toxic for EM equities in periods of positive growth. For example, EM stocks did well in 1999 and 2004 when tighter US monetary policy was accompanied by strong economic and earnings growth. (EM equities also performed poorly in 2015 and 1994 when US rates were steady, but growth was weak.)

The bottom line for investors is that there are good reasons to be positive about EM equities and currencies. For equities, much of the re-rating reflects gains in currency valuations, and the brighter earnings and macro outlook have not yet been reflected. On currencies, we are overweight a basket of EM currencies – ruble, real, rand, and rupee – versus a group of G10 currencies. These EM currencies offer an appealing interest rate differential – around eight percentage points – and at a time of improving economic growth there is less risk that these currencies will weaken.

Authors:

Mark Haefele, UBS Global Chief Investment Officer Wealth Managementand

Christopher Swann, UBS Global Investment Office

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