Supportive valuations, under-ownership by global equity funds and strengthening profit margins are just some of the reasons why emerging markets could outperform developed markets again in 2018, according to Hermes Investment Management’s Gary Greenberg. 
The past decade has been a tough one for emerging market investors with the MSCI Emerging Markets index posting a total return of 87.02 per cent over 10 years. The developed market-focused MSCI World index rose 153.79 per cent over this time.
However, the emerging market index beat the MSCI World in both 2016 and 2017 – its 25.50 per cent return last year being much higher than the 11.80 per cent made by developed market stocks. FE Alpha Manager Greenberg, head of emerging markets at Hermes, expects this to continue over the coming year.
“Two years ago, we argued that 2016 was a year of transition for emerging markets [EMs]. After five years of underperformance relative to developed markets [DMs], favourable winds were stirring: we saw early signs that the commodity cycle was bottoming out, productivity among EM companies was improving and the US dollar was likely to peak,” the manager of the Hermes Global Emerging Markets fund said.
Performance of indices since start of 2016
Source: FE Analytics
“These forces would strengthen in the coming two years, after which EMs would become a major investment theme. At the outset of 2018, it is clear that the tailwinds have arrived.”
Greenberg argued that emerging markets are undergoing a “secular transition” away from being a destination for short-term trading, where hot money flows are dictated by commodity cycles or currency swings, to a home for long-term investment capital.
Emerging market nations have achieved a healthier balance between imports and exports, lowered their debt levels and witnessed declined inflation, putting on them on the path of sustainable growth rates. On the corporate side, profit margins have recovered, balance sheet strengthened and earnings estimates rose.
In light of this, the manager said there are six reasons why the tailwinds for emerging markets should continue to strengthen in 2018.
1. Profits: margin gains
Net non-financial profit margins in emerging markets have recovered from a 5.5 per cent trough in 2015 – which is nearly a 20-year low – to reach 6.7 per cent in 2017. There is still room for improvement as margins remain below the 7.7 per cent 20-year average and the 10.5 per cent peak seen in 2008.
However, developed market margins have little room for manoeuvre and are close to their 20-year peak. Only four emerging market countries are at a similar level: Turkey, Indonesia, Hungary and South Korea.
“This is driving an improvement in return on equity [RoE], which bottomed alongside margins in 2015, and we expect further gains this year,” Greenberg said. “On a relative basis, EM margins and RoE are slightly better than those in DM. Crucially, however, EM companies continue to trade at a substantial discount on the basis of price-to-book valuations.”
2. Macroeconomic momentum
GDP growth in emerging market economies relative to developed markets decelerated sharply between mid-2010 and the first quarter of 2016, moving from being 7 per cent faster to just 2.5 per cent ahead.
Consensus real GDP growth forecasts for EM countries (GDP weighted, %)
Source: Hermes Investment Management, Bloomberg, Credit Suisse as at January 2018
“According to forecasts, economic growth in EMs bottomed early last year and was followed by upward estimates for 2017 and for 2018,” the manager said. “Indeed, EM growth is picking up speed in absolute and relative terms, with or without China, and the International Monetary Fund forecasts a continuation of this trend, leading to a 4 per cent differential with DMs over the next three years.”
3. EM currencies still undervalued
When the ‘taper tantrum’ struck markets in May 2013, emerging markets were net borrowers and still vulnerable to US monetary-policy tightening. Brazil, India, Indonesia, Turkey and South Africa all had negative current accounts and emerging markets as a whole owed foreign creditors 1.1 per cent of their combined GDP.
However, Greenberg pointed out that the situation is much different today as emerging market companies are net lenders to foreigners, accounting for about 5.6 per cent of GDP. Brazil, India and Indonesia are running close to balanced current accounts, as is much of the emerging market world.
The manager said this will make emerging markets more resilient to ongoing US interest rate normalisation and he does not expect their currencies to rally strongly in 2018 against the dollar.
4. Capex: dawn of a new cycle?
Capital expenditure (capex) in emerging markets – aside from China in 2009 – has been subdued in recent years despite greater need for spending on property, plant and equipment within these economies. Year-on-year capex growth for emerging markets troughed at -15 per cent in US dollar terms in 2015 and remains in negative territory.
“While this may lead to insufficient future growth in productive capacity, it certainly underpins the argument that there is ample room for an increase in capital spending throughout EMs,” Greenberg said. “And if this happens, it is likely that EMs will outperform DMs, following the precedent set by previous capex cycles.”
5. EM stocks are not a crowded trade
Investor interest in emerging markets appears to have resumed but “remains far from euphoric", according to the manager. The average global equity fund is heavily underweight emerging market equities, with an allocation of 8.3 per cent compared with a weighting of 12.7 per cent in the MSCI AC World index.
Greenberg added: “EM price momentum, while healthy, is far from parabolic. The current bull phase is young and calm: the universe has gained 20 per cent in the two years since January 2016, whereas EM stampedes typically outperform DMs by 79 per cent over 88 weeks.”
EM relative return bull runs: current v previous episodes
Source: Hermes Investment Management, MSCI, Credit Suisse research as at January 2018. Notes: Relative to MSCI World inception of MSCI EM on 1 January 1988.
6. Valuations looking good
Emerging markets have recovered from the troughs they fell into in recent years, meaning not all stock metrics are better than those in the developed world; however, they remain cheaper than the US.
“EM stocks are trading in line with their long-term averages of price-to-earnings and price-to-book metrics. The discounts they trade at relative to the MSCI World index also reflect their long-term averages,” the manager concluded.
“In comparison with the US, which is generally considered expensive relative to its own history – on the basis of its cyclically adjusted PE ratio and earnings growth – EMs look attractive.”
Greenberg has managed the $3.4bn Hermes Global Emerging Markets fund since July 2011, over which time it has generated an 85.81 per cent total return. This makes it the best performer of the IA Global Emerging Markets sector and represents significant outperformance of the MSCI Emerging Markets index’s 37.91 per cent gain.
The five FE Crown-rated fund is run with a benchmark-agnostic approach and has a concentrated portfolio of 51 stocks. Top holdings include Samsung Electronics, Tencent, Taiwan Semiconductor Manufacturing, Naspers and Techtronic Industries.
Hermes Global Emerging Markets has an ongoing charges figure (OCF) of 1.13 per cent.