By Steve Cao, Senior Portfolio Manager
Emerging markets fell by approximately 2% in US dollar terms during the first quarter — significantly underperforming the developed world, as defined by the MSCI EAFE Index which was up over 5% during the quarter, — largely because of earnings downgrades and macro headwinds, especially an overall growth trend that was slower and weaker than expected. Across emerging markets during the first quarter, we saw:
- Deceleration in Asia, driven by slower export recovery.
- Slowing down in Latin America, driven by weaker commodity demand and higher consumer gearing.
- A sharp slowdown in Eastern European economies due to economic downturns in the eurozone.
In addition to slower growth, other economic fundamentals deteriorated, especially the higher current account deficits and higher inflation in an increasing number of emerging market economies. These deficits and inflation will constrain policymakers' ability to be flexible and accommodative in monetary and fiscal policies. In some economies where inflation and current account deficits are already at elevated levels — as in Brazil, Indonesia and Turkey — the easing bias we've seen could be removed, thus increasing the risk that interest rates may rise.
On the earnings front, all emerging market regions posted more earnings disappointments during the fourth quarter, driven by slower top-line growth and margin compression. Corporate profit margins continued to fall, driven mainly by rising labor costs. Emerging market regions have seen record wage growth over past several years, attributable in part to a shrinking population of working age. This is more of a structural, secular trend as opposed to a shorter-term cyclical one.
The decline in commodity prices has a much larger impact on corporate earnings of emerging markets because the commodities sector accounts for a far larger share of the their economic output and corporate earnings than developed markets. Consequently, the recent weakness in commodity demand has hurt earnings of the emerging market companies more than earnings of companies in developed markets.
The consensus forecast for 2013 for emerging market earnings is 13% growth. The overall market valuation looks attractive with a P/E multiple 11 times — this is below its long-term average — and is at a 20% discount to developed markets.
Several significant events affected emerging markets during the first quarter, particularly in China and Japan. The new Chinese government — which has pledged to continue economic reforms and rebalancing the economy — is apparently tolerating slower growth than the previous governments. One indicator of this is tighter policies in the property market, including a 20% capital gains tax and higher down payments on second home purchases. The government has also imposed new restrictions on wealth management products to help control bank lending. Overall, stable growth and continued market reform seem to be key priorities of the new government.
Japan's quantitative easing program will have both negative and positive impacts on emerging market economies. On the negative side, the cheaper yen will hurt the competitiveness of Asian companies, especially in Japan, South Korea, Taiwan and China, and we could see earnings pressure for the affected companies in those economies. The other negative effect is liquidity flow, which could translate into higher inflation for those economies outside Japan.
On the positive side, reflation from Japan's fiscal and monetary policies could boost Japanese economic growth, which should be positive for emerging markets by increasing exports to Japan. At this point, it's difficult to gauge the long-term impact because it remains to be seen whether the increase in monetary base in Japan will lead to a sustainable recovery in the Japanese economy. We have some doubt it will.
Emerging markets have lagged developed markets for some time now. In our view, earnings data are likely to be the most important catalyst before emerging markets start to outperform again relative to the US and developed markets. We don't see consistent signs that the earnings trend is stabilizing. In some economies, such as China's, this down cycle appears to be bottoming out as corporations benefit from lower commodity prices. Other economies still face challenges as China's growth slows, which could pose downside risks to earnings, especially in those that rely on commodity exports.
Steve Cao is a senior portfolio manager for Invesco International/global growth products. Read more about Mr. Cao.
Political and economic conditions and changes in regulatory, tax or economic policy in Japan or China could significantly affect the market in that country and surrounding or related countries.
Sovereign debt securities are subject to the additional risk that — under some political, diplomatic, social or economic circumstances — some developing countries that issue lower quality debt securities may be unable or unwilling to make principal or interest payments as they come due.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified funds.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
FOR US USE ONLY
Note: Not all products, materials or services available at all firms. Advisors, please contact your home office.
The opinions expressed are those of the author, are based on current market conditions as of April 12, 2013, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This information should not be relied upon as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor.
Lipper is the source for index and market return data as of March 31, 2013.
The MSCI EAFE® Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East.
Past performance cannot guarantee comparable future results.
The price-earnings ratio (P/E ratio) is a valuation ratio of a company's current share price compared to its per-share earnings.