Emerging markets: Data brings light at end of tunnel

In spite of ongoing political machinations in the eurozone, cautious optimism appears to have returned to emerging market equities, as economic data has revealed that there may be some light at the end of the tunnel.

Emerging market equity valuations remain at historically low levels. These valuations are even more appealing when considered in relation to earnings per share. During the height of the credit crisis – between July 2008 and November 2009 – earnings per share suffered a significant drop of 42 per cent.

Crucially, however, during the more recent bout of volatility, with heavy falls suffered by global equity markets between August and September 2011, earnings per share have only incurred a 4 per cent drop.

This suggests that the recent market falls were more a result of panic selling rather than negative sentiment over company fundamentals. Furthermore, as at the end of 2011, the stocks traded at 9.1 times their future earnings. This is one standard deviation below the long-term mean of 11.4 (between 1999 and the end of 2011).

This would indicate that the markets have already discounted a scenario of low growth and could pave the way for recovery from this point forward.

So where are the opportunities to be exploited? We expect attractive relative performance from the Latin American region, in particular Mexico and Brazil. State interference tends to be relatively low, notably in Mexico.

Meanwhile, we expect the US economy to outperform its developed market peers in coming periods, which would again tend to favour some Latin American companies. Finally, there are a number of stocks, such as Brazilian iron ore miner Vale, which are trading as cheaply as they have ever done. We believe it is important to own high-quality stocks with strong franchises, and Vale fits this category.

At the sector level, our conviction remains significantly skewed towards the consumer. We believe that rising incomes and relatively low levels of private sector debt in emerging markets gives consumers significantly greater willingness and ability to buy a range of items. We are also overweight in elements of the production chain, particularly in goods and services related to infrastructure – from iron ore mining to road building.

However, defensive sectors such as telecommunications, utilities, energy and information technology are likely to offer the least value but significant volatility.

The outlook for global emerging markets remains clouded by the uncertain outlook for growth. Europe’s currency and banking issues are critical for markets and economies. But for all the focus in this area, a number of other concerns exist: China’s lending practices and industrial competitiveness have come under scrutiny, and US economic growth, although more robust than most developed markets, is still lacklustre.