Economic growth projections for emerging markets are finally starting to show signs of restoration from modest levels, having bottomed in the second quarter of this year. The ensuing rebound has steadily been translating into more positive earnings expectations after a lengthy period of net downward revisions.
The early signs of a breakout from these negative ranges have been encouraging, although the breadth of the breakout is likely to be a slow-burn process.
Earnings revisions are currently concentrated in commodity-related sectors, such as energy and materials. That said, information technology has begun to see upward revisions and the financials and utilities sectors are starting to see a stabilisation in earnings expectations too, with neither sector joined at the hip to the commodities story. A similar broadening out is taking place at a country level, with Hungary, South Korea and Thailand (countries less influenced by the commodities outlook) seeing upward revisions.
Similar to earnings expectations, reported earnings are no longer falling or correcting as sharply, and there’s a much better balance when it comes to earnings surprises, with the number of positive earnings surprises increasing (a notable change from several quarters ago). Bottom lines are also improving where, in some cases, top lines may be lacklustre.
Good examples of this trend are Russia and India, where earnings realisations are often beating expectations in the absence of positive revenue surprises.
Cashflow analysis shows that in a world where margins have been pushed down over the past few years owing to commodity pressures, the emerging markets (ex-commodity) space has made good progress over the past couple of quarters, moving slightly off the bottom.
And it’s a similar story for emerging markets including commodities where we’re seeing an improvement in profit margins following a bottoming out.
How might the turn in both profit margins from cyclical lows and reported earnings influence the earnings growth trajectory from here?
Forecasts suggest that most return on equity (ROE) figures will be higher three years from now (assuming a more normal earnings cycle). But what’s striking is that the biggest earnings rebound is expected to take place in the ‘cyclically depressed’ material and energy sector, although we think it premature for investors to become bulls on commodities.
The ROE remains at the low end compared to other sectors so investors would do well to err on the side of caution with respect to the rebound.
When the numbers across sectors are aggregated, there is a normal ROE that’s close to 14 per cent – a figure that’s very close to the long-term average profitability level in emerging markets.
While current asset class valuations are not as cheap as they were at the start of this year, when the price-to-book ratio bottomed at 1.2x, the asset class remains moderately cheap relative to historical averages.
North Asia, particularly South Korea, currently offers an attractive combination of value and momentum. Russia bears similar characteristics and, while it has been a good performer year to date, the equity market appears to still have a lot of value to offer.