After five painful years of underperformance by almost 50% in U.S. dollar terms versus developed markets, emerging markets equities are enjoying a rebound. At Barings, we believe that the recovery in corporate earnings has been a key underpinning for the rebound and we remain optimistic that the improving earnings outlook will sustain this trend ahead.
We need only to observe EM equity performance from 2011 to 2015 to appreciate how powerful the earnings cycle is as a driver of stock market returns. At the start of each year, earnings expectations would peak before experiencing a steady and sustained decline as companies failed to meet analyst forecasts. As a result, EM equities declined by more than 30% in U.S. dollar terms during the period and only began to recover in 2016 and 2017.
So which factors hurt performance and have they changed? Over 2011 to 2015, EM companies suffered a double whammy of falling profit margins and slowing sales growth. Profit margins declined because real wage growth exceeded productivity growth, while sales performance was negatively impacted by weaker nominal GDP growth. Consequently, EM corporate earnings did not grow over the period and, unsurprisingly, the MSCI Emerging Markets Index failed to make any progress either.
However, these headwinds have started to reverse and the EM corporate earnings cycle has now passed an inflection point. Profit margins are beginning to recover as productivity growth is outpacing real wage growth, thanks to previous investment in labor-saving equipment and a renewed focus on cost management. Meanwhile, sales performance is also improving due to accelerating real GDP growth across emerging markets and rising inflation in many countries.
This translated into positive earnings growth in 2016 for the first time since 2011, and earnings growth has significantly accelerated in 2017. Positively, we expect this will continue into 2018 and are encouraged to see the earnings recovery continue to broaden, with all 11 major sectors of the MSCI Emerging Markets Index now forecast to grow both this year and next.
We believe the profit margins recovery is largely non-cyclical in nature and can therefore support corporate profit performance beyond 2018. In addition, approximately 70% of the MSCI Emerging Markets Index is now comprised of information technology, financials, consumer and healthcare stocks. All of these sectors have potential for strong secular growth as they remain underpenetrated and stand to benefit from the ongoing expansion of the EM market middle class.
The fact that global investors remain significantly underweight while valuations also appear attractive should add further support to the asset class. Only U.S. $ 45 billion of inflows have returned to emerging markets compared to the U.S. $155 billion redeemed over the past couple of years. We expect investor appetite to grow as the earnings recovery strengthens at a time when valuations appear attractive, particularly on a price-to-book basis and when looking at the cyclically-adjusted price to earnings ratio.
While EM equities appear attractive at the market level, we believe that active managers who employ a disciplined investment process backed by specialist expertise in EM equity investing and a strong bottom-up research capability will reap the greatest rewards. In our view, the ability to look in-depth at a company business model and to truly understand its strengths, weaknesses and the overall operating environment are critical when seeking to identify companies with unrecognised growth.
This article was provided by Barings and does not necessarily reflect the views of Citywire