Buy the Dip in Emerging Markets?

Transcription

1 October 8, 214 EGA Investment Strategy Commentary Buy the Dip in Emerging Markets? Recent underperformance and asset outflows have contributed to investors underweight in their emerging market allocations versus benchmark weights. The tide, however, may be turning. Compelling valuations, positive growth surprises, recovering profitability, and the potential for economic reforms provide the foundation for a recovery in emerging markets. This recovery could broaden to include cyclical sectors and value stocks that tend to do well when growth accelerates, liquidity is ample and risk appetite is increasing or high. HIGHLIGHTS: Investors are underweight emerging market benchmark weights Valuations, growth, profitability and structural economic reforms make emerging markets attractive A recovery in emerging markets may be on the horizon Investors are underweight emerging market allocations Investors have faced a number of headwinds in emerging markets over the last few years. First, the MSCI Emerging Markets (EM) Index has underperformed other world and regional indices over the last one, three and five years (see Figure 1) and, in absolute terms, has generated a negative annual return of.4% since the end of 27. FIGURE 1: Performance of major global equity indices versus MSCI EM Index (9/3/29 9/3/214) Index Performance % % % 7% 6% 5% 4% 3% 2% 1% % 1-year 3-year 5-year MSCI EM Index MSCI World Index MSCI EAFE Index S&P 5 Index Source: Bloomberg, MSCI, EGA. Data as of 9/3/214. Past performance does not guarantee future results. Second, since the U.S. Federal Reserve warned of tapering its asset purchasing program in May 213, investors have fled the asset class. Emerging market ETFs had $3.1 billion of outflows in 213 and $12.6 billion in the first quarter of 214, although fund flows began to reverse in the second quarter of 214 with inflows of $8.7 billion (see Figure 2). However, in comparison with inflows into European and U.S. equity ETFs this year, emerging market equity funds have been less popular. FIGURE 2: Representative ETF fund flows (millions of shares) (1/2/29 9/26/214) Shares outstanding Shares outstanding Shares outstanding 13 1 EM Equity ETF (EEM) 7 '9 '1 '11 '12 '13 ' European Equity ETF '9 '1 '11 '12 '13 ' US Equity ETF (SPY) 5 '9 '1 '11 '12 '13 '14 Source: Bloomberg, EGA as of 9/26/214. EEM is the ishares Emerging Markets ETF, VGK is the Vanguard FTSE Europe ETF and SPY is the SPDR S&P 5 ETF. These ETFs are being used as proxies for investor flows into Emerging Market, European and U.S. equity ETFs. EGA is unaffiliated with ishares, Vanguard or SPDR and is not offering EEM, VGK or SPY for sale. Past performance does not guarantee future results. According to Morningstar, the average U.S. investor has about a 3% 4% allocation to emerging market equities, while emerging market equities account for 1% of the global equity market based on a market capitalization weighting. 1 Overall, investors are underweight emerging markets. 1. What is Your Emerging-Markets Allocation?, Patricia Oey, Morningstar.com, September 1, 214. Data based on aggregated Morningstar fund data as of August 214. EGA Investment Strategy Commentary 1

2 Valuations are compelling The poor absolute and relative performance have left emerging market equities at lower valuations compared to other global equity indices and to their own history. The MSCI EM Index trades at 1.3 times its projected 12-month earnings, a discount of 3% compared to the MSCI World Index (see Figure 3). The average discount since June 23, however, is 21%, indicating that there may be opportunity for a multiple expansion as a part of mean reversion. FIGURE 3: 12-month Forward Price to Earnings ratio (6/3/23 9/3/214) 12-mth forward P/E Source: Bloomberg, MSCI, EGA. Data as of 9/3/214. Past performance does not guarantee future results. Valuations are also compelling based on the Shiller P/E ratio. One of the drawbacks of the traditional price-to-earnings ratio is that it only values earnings over one time period. The Shiller P/E attempts to smooth out the profit cycle and provides as a more accurate assessment of valuations. On this measure, the MSCI EM Index is below 14 times earnings, one standard deviation below its average since 25 (see Figure 4). FIGURE 4: Shiller P/E ratio (12/31/1987 9/3/214) MSCI EM Price Index '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 MSCI EM Index MSCI World Index S&P 5 Index s.d. P/E average P/E -1 s.d. P/E '88 ' '92 '94 '96 '98 ' '2 '4 '6 '8 '1 '12 '14 MSCI EM Index Shiller P/E (rhs) Source: Bloomberg, MSCI, EGA. Data as of 9/3/214. Past performance does not guarantee future results Shiller price-to-earnings ratio Growth should improve and profitability should recover Beyond the opportunity for contrarians to capitalize on an out-offavor asset class, there are three catalysts that could improve fundamental growth and profitability in emerging markets. First, emerging market economic growth has been beating consensus forecasts, as indicated by the UBS Growth Surprise Indices that have been improving in comparison with the rest of the world since the start of 214. Figure 5 demonstrates that the relative performance of the UBS EM Growth Surprise Index relative to UBS Global Growth Surprise Index troughed at the beginning of 214, but the MSCI EM Index has nonetheless underperformed the MSCI World Index. We expect emerging FIGURE 5: Relative growth surprise vs. relative performance (Emerging Markets vs. Developed Markets) (12/31/211 9/3/214) Relative Growth Surprises Index Source: Bloomberg, MSCI, UBS, EGA. Data as of 9/3/214. Past performance does not guarantee future results. market equities to perform better if emerging market growth continues to beat expectations. Second, earnings estimates have been cut from a double digit growth rate at the start of the year to a more achievable estimate of 5.1% (Figure 6). While this is not such an impressive rate of growth, it is both consistent with the long run earnings growth rate in emerging FIGURE 6: Emerging market earnings growth estimates Earnings growth % 1% Dec-11 8% 6% 4% 2% % Mar-12 Jun-12 Sep % 214e Dec-12 Mar-13 Jun-13 Source: Bloomberg, EGA. Data as of 9/3/214. Sep-13 Dec-13 Mar-14 UBS EM Surprise Index relative to Global Surprise Index MSCI EM Index relative to MSCI World Index (rhs) 9.7% 215e Jun-14 Sep Relative performance EGA Investment Strategy Commentary 2

3 markets as well as being more realistic and achievable. This means that valuations are more reliable and credible; investors do not have to charge an additional discount for accepting emerging market risk. FIGURE 7: Emerging market ROE (26 215e) Return on Equity 18% 16% 14% 12% 1% 8% 6% 4% 2% % e 215e Source: Bloomberg, MSCI, EGA. Data as of 9/3/214. ROE is ex-financials. Past performance does not guarantee future results. Third, return on equity (ROE), which has been in decline since 21, appears no longer to be deteriorating. EGA estimates that corporate ROE troughed at 1.9% in 213 and should recover slightly to 11.1% in 214 and 11.5% in 215. An improvement in earnings growth and ROE should allow valuations to recover from their current level of 1.5 times 214 and 9.5 times 215 estimated earnings. Reform Additionally, there is the possibility of fundamental economic reform throughout emerging markets, which is being demanded both by financial market participants and by local populations through protests and the ballot box. For example, China, India and Mexico have explicit reform programs designed to improve productivity and growth, while there is also the possibility for reforms in Brazil depending on the outcome of its upcoming presidential election. China: The leadership in China intends to ease capital controls, deregulate interest rates and partially privatize state-owned enterprises. These changes should improve capital allocation and the profitability of the corporate sectors. India: The new Indian government, led by the recently-elected Prime Minister Narendra Modi, intends to deregulate the labor market, upgrade infrastructure and reduce the fiscal deficit by cutting subsidies. These improvements should unleash investment, increase efficiency and raise productivity. Mexico: Monopolies and oligopolies in the energy and telecommunication sectors are likely to be broken in order to encourage investment and growth. Brazil: The stock market has fluctuated as opinion polls have indicated an erosion of support for President Dilma Rousseff, whose intervention in free market pricing has led to a lack of investment and poor economic growth. President Dilma Rousseff runs against the pro-business candidate, Aecio Neves, in the second round of the presidential eleciton on October 26. The result is too close to call and continued market volatility is likely. FIGURE 8: 214 Emerging market election timetable Country Election for Date Result Platform Brazil President October 26 TBD Colombia House of Representatives March 9 Party of the U wins Peace, growth, foreign policy Colombia President June 15 Juan Manuel Santos wins Peace, growth, foreign policy Egypt President May 26 Abdel Fattah el-sisi wins Stable government Hungary National Assembly April 6 Viktor Orbán wins Stabilize economy India General Election April May Narendra Modi wins Reforms, reduce corruption Indonesia House of Representatives April 9 Indonesian Democratic Party wins Reforms, reduce corruption Indonesia President July 9 Joko Widodo wins Reforms, reduce corruption South Africa National Assembly May 7 African National Congress wins Economy, jobs Thailand House of Representatives Delayed TBD Turkey President August Recep Tayyip Erdogan wins Economy Source: EGA. EGA Investment Strategy Commentary 3

4 The concept of reform is gathering momentum in emerging markets and could cause a re-rating of the asset class as investors anticipate the possibility of a virtuous circle of lower deficits, inflation and interest rates, and stronger currencies and growth in the longer term. Elections throughout the emerging world in 214 provide the opportunity to implement fundamental reforms in many countries (see Figure 8). would benefit from any cyclically-led emerging market recovery. The potential for this cyclically-led recovery is supported by a style analysis of emerging market equity performance. As can be seen in Figure 1, the outperformance of Cyclicals over Defensives is akin to the outperformance of Value over Growth. The Value style tends to do well when growth accelerates, liquidity is ample and risk appetite Increasing cyclical exposure? Since 21, market leadership has been narrow and concentrated in the small, defensive sectors of health care, consumer staples, telecoms and utilities (see Figure 9). These sectors were the only ones to have exhibited earnings growth and lived up to their namesake. In contrast, many cyclical parts of the MSCI EM Index (consumer FIGURE 9: MSCI EM Index: Cyclical sectors poised to take over market leadership (12/31/21 9/3/214) FIGURE 1: EM style performance: An opportunity for Defensives/Cyclicals? (12/31/28 9/26/214) Defensive relative to Cyclicals Growth relative to Value Cyclicals vs. Defensive performance Defensive Outperforming Cyclicals Outperform? '2 '3 '4 '5 '6 '7 '8 '9 '1 '11 '12 '13 '14 Cyclicals vs. Defensive Performance Source: Bloomberg, FactSet, MSCI, EGA. Data as of 9/3/214. Past performance does not guarantee future results. discretionary, energy, materials, financials, industrials and technology) have suffered from anemic earnings growth and consequently poor performance. The economically-sensitive sectors would be supported by a recovery in emerging market GDP growth and an end to negative earnings revisions. Broad emerging market indices such as the MSCI EM Index, comprising mainly cyclical sectors, Source: Bloomberg, EGA. Data as of 9/26/214. Past performance does not guarantee future results. Definitions of those stock attributes that EGA uses to define Growth, Value, Defensive and Cyclicals categories are in the Definitions section of this paper. Stocks included in these categories will vary, as will their weights. is high or increasing; Growth outperforms when the reverse is true. Conclusion Defensive/Cyclicals Growth/Value (rhs) The contrarian will likely notice that investors are underweight emerging market benchmark weights, that emerging market economic growth has started to surprise to the upside and that negative earnings revisions appear to have come to a halt. Supported by attractive valuations, improvements in profitability and reforms to improve growth potential, emerging market equities should rebound from the slump in September. We think that market leadership could broaden from the narrow, more defensive sectors. In short, we think that investors should take these cues to close their underweight to emerging markets. 65 EGA INVESTMENT STRATEGY TEAM: Nicholas Smithie Chief Investment Strategist Edward Kerschner, CFA Vice Chairman Steve Mo Investment Strategist Neeraj Agarwal Investment Strategist emergingglobaladvisors.com EGA Investment Strategy Commentary 4

5 Definitions Cyclicals includes the Consumer Discretionary, Energy, Materials, Financials, Industrials and Information Technology GICS sectors. Defensive includes the Consumer Staples, Health Care, Telecommunications and Utilities GICS sectors. Forward Price to Earnings (P/E) Ratio for a single company is calculated by taking the current stock price and dividing it by the estimated future 12-month earnings per share; for an index, it is the market cap-weighted sum of each company s price-to-earnings ratio. Gross Domestic Product (GDP) is the market value of all goods and services produced within the economy in a given period of time. Growth represents the most expensive quintile of stocks within the MSCI EM Index based on an equal-weighted ranking of 12-month forward P/E, trailing P/B and trailing dividend yield. Emerging Markets (EM) is based on those countries included in the MSCI EM Index, including the following countries: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey & UAE. MSCI All Country World Index (ACWI) captures large and mid-cap representation across 23 developed markets and 23 emerging markets countries. MSCI Emerging Markets Index is an index that is designed to measure equity market performance in global emerging markets. MSCI Emerging Markets Price Index represents the price return of the MSCI EM Index. MSCI EAFE (Europe, Australasia, Far East) Index is an index covering developed market countries in Europe, Australasia, Israel and the Far East. MSCI Frontier Markets Index is an index that captures large and mid cap representation across 24 Frontier Markets countries. MSCI World Index is an index that captures large and mid cap representation across 23 Developed Markets countries. Return on Equity (ROE) is the amount of net income earned as a percentage of shareholders equity. S&P 5 Index is a broad-based measure of U.S. stock market performance. Shiller P/E Ratio is calculated by taking the current stock price and dividing it by the average annual earnings over the last ten years, adjusted for inflation. Standard Deviation is the square root of the variance; a measure of dispersion in the same units as the original data.value represents the least expensive quintile of stocks within the MSCI EM Index based on an equal-weighted ranking of lowest P/E, lowest P/B and highest dividend yield. UBS Surprise Indices are indices that measure when incoming economic data differs from consensus expectations; the UBS Global Growth Surprise Index measures global economic data; the UBS Emerging Market Growth Surprise Index measures emerging market data. One cannot invest in an index. Disclosures and Risks Investors should carefully consider the investment objectives, risks, charges and expenses of a Fund before investing. To obtain a prospectus for any EGA or EGShares Fund and other important information, as well as to obtain most recent index performance, please call or visit emergingglobaladvisors.com to view or download a prospectus. Read the prospectus carefully before investing. Emerging market investments involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, from economic or political instability in other nations or increased volatility and lower trading volume. Small and mid-cap companies generally will have greater volatility in price than the stocks of large companies due to limited product lines or resources, or a dependency upon a particular market niche. Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses, which could reduce returns. Indexes are unmanaged and one cannot invest directly in an index. The content of this presentation is presented for general information purposes only. Nothing contained herein should be considered a recommendation or advice to purchase or sell any security. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and it should not be relied on as such or be the basis for an investment decision. The statements and opinions expressed are those of Emerging Global Advisors, LLC and are as of the date of this presentation. All information is historical and not indicative of future results, and subject to change. This presentation may include estimates, projections and other forward-looking statements. Due to numerous factors, actual events may differ substantially from those presented. Emerging Global Advisors, LLC assumes no duty to update any such statements. Past performance is no guarantee of future results. The MSCI information may only be used for your internal use, may not be reproduced or disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an as is basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the MSCI Parties ) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. EGA Investment Strategy Commentary 5

6 Disclosures and Risks (continued) The Global Industry Classification Standard ( GICS ) was developed by and is the exclusive property and a service mark of MSCI Inc. ( MSCI ) and Standard & Poor s, a division of The McGraw-Hill Companies, Inc. ( S&P ) and is licensed for use by Emerging Global Advisors, LLC. Neither MSCI, S&P nor any third party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability and fitness for a particular purpose with respect to any of such standard or classification. Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. ETF shares are not individually redeemable and owners of the shares may acquire those shares from the Funds and tender those shares for redemption to the Fund in Creation Units only, typically consisting of aggregations of 5, shares. Nicholas Smithie and Edward Kerschner are Registered Representatives of ALPS Distributors, Inc. EGShares Funds ( Funds ) and the SPDR S&P 5 ETF, a unit investment trust, are distributed by ALPS Distributors, Inc. ALPS, SPDR and Emerging Global Advisors are unaffiliated entities. 214 Emerging Global Advisors, LLC. All rights reserved. EGA SM, EGShares SM and EGAI SM are service marks of Emerging Global Advisors, LLC. All other trademarks, service marks or registered trademarks are the property of their respective owners. EGS25 Expires 1/1/215 EGA Investment Strategy Commentary 6