Equities on cusp of ‘breakout’ despite headwinds

But while these headwinds persist, there are early signs that EM equities may now be worth another look. Certainly, over the first quarter of 2016 in particular, EM and Asia-Pacific ex Japan equities led the rebound in global stocks, with EM equities seeing multiple reratings.

However, questions remain about the sustainability of the recent rally, which has yet to be underpinned by stronger fundamentals. This has led investors to question whether this is just a temporary bounce or the beginning of what some might call the ‘breakout’.

Throughout the EM bear market of the past four years, there have been six instances where EMs have risen more than 10 per cent in absolute terms, only to later continue their secular decline.

Markets have also seen four episodes in this period where the area’s stocks have outperformed global equities by five percentage points, similar to the magnitudes markets have seen year to date.

All of this suggests that the recent turnaround could be seen as a risk rally, and there may not be enough evidence in itself to justify a breakout.

In the near-term, much depends on the path of the US dollar, which tends to heavily influence EM flows and valuations. In recent years the strength of the US currency has been a significant headwind for EM and Asia-Pacific equities.

The ultimate catalyst for a sustainable recovery in EM equities will be an earnings pick-up Emily Whiting, JP Morgan Asset Management

In early 2016 this trend went into reverse, with the dollar rapidly retracing rather dramatically to a four-year low on a trade-weighted basis.

It may be premature to judge whether the US currency’s multi-year bull market has ended, but if the dollar has peaked and is now weakening, then there is potential for a breakout in EM equities.

However, if the dollar’s rise has merely paused, we will probably look back at the first-quarter rally and say it was a bounce – a powerful bounce, but not the decisive upturn investors have been waiting for.

In the longer term, there are a couple of key performance drivers to watch to ascertain when the tide has officially turned for the asset class.

EM equity performance relative to developed markets has historically moved in tandem with GDP growth expectations for the emerging versus the developed world.

The underperformance of the EM equity index over the past two years reflects the fall in growth expectations for the asset class, as expectations for developed markets have remained relatively stable.

For EM equities to outperform, at least one of two things needs to happen: EM GDP growth expectations need to improve – while developed markets remain stable – or developed market growth expectations fall further.

Developed market economies are likely to grow at their current pace for the next year or so – it is therefore EM expectations that need to gain momentum.

However, the ultimate catalyst for a sustainable recovery in EM equities will be an earnings pick-up. Investors looking to get back into the asset class should monitor earnings expectations closely – at the headline level, in the broad EM regions and at the individual country level.

Some EM markets and companies are better positioned than others to benefit from an improving global backdrop, and investors need to navigate carefully to clasp the favourable trade winds and avoid the undertow. This means a highly selective, bottom-up approach is a good way to start adding exposure.

Investors need to watch the economic fundamentals and be mindful of the all-important path of the US dollar, but a sunnier patch for EM may be in the forecast.

Emily Whiting is client portfolio manager at JPMorgan Asset Management