Despite EM risks, DWS upbeat on valuations

Asset Class in Focus

The emerging market index was double-digit negative in 2018, but DWS’s APAC chief investment officer says valuations in EM equities have rarely been cheaper.

Sean Taylor, DWS

“After a de-rating in 2018, emerging market equity valuations are now below long-term averages. Relative to developed markets, their valuations are at a very low level, trading at a 20% discount,” said Sean Taylor at a recent media briefing.

He expects high-single-digit earnings growth across the asset class for the next 12 months, supported by improving operating leverage as many companies have restructured during the decade since the global financial crisis.

“In particular, emerging market Asia has de-rated over the last month and we expect markets to rally as the prospect of a trade agreement between the US and China approaches,” said Taylor.

Although the MSCI Emerging Markets Index plunged in calendar year 2018 (-14%) and remains negative (-11.5%) for the trailing 12 months, Taylor sees at least five reasons to be sanguine about emerging market equities.

Reasons to be cheerful

First, the US Federal Reserve is likely show restraint by raising interest rates only once this year. Second, the dollar should be flat-to-weaker because of the reversal in the Fed’s hawkish stance.

Third, China economic growth should recover as stimulus measures undertaken by policymakers late last year promote consumption and credit expansion.  A stronger China would be a catalyst for a surge in global economic activity.

Fourth, the US-China trade dispute (in its current form) is likely to be resolved soon, with China agreeing to buy more goods from the US.

Finally, the contagion that has typically afflicted emerging market asset prices in the past seems to have subsided, as evinced by the strength of the Brazil market last year despite political chaos in Venezuela, economic turmoil in Argentina and investors’ suspicions about the intentions of Mexico’s new administration.

DWS is overweight China, Thailand, Brazil and Russia due to healthy growth prospects and low market valuations, and neutral towards India and Indonesia where major elections are likely to be a dampener on investor sentiment.

Its underweights are Taiwan and South Korea because of possible fall-outs from US-China tensions over technology, Mexico due to the left-leaning populist stance of the new government and South Africa, Turkey and central Europe because of a combination of political worries and economic imbalances.

The key risks to his rosy outlook are “slower global economic growth and a spike in developed market volatility, a delay in China’s stabilisation and geopolitical shocks”, said Taylor.

Modest developed markets

Overall, Taylor forecasts “middle- to high-single-digit total returns for global equities, driven by modest earnings growth and meaningful contribution from dividends.

“After a strong rally at the start of the year, equity markets seem to be fairly priced and there will not be an earnings recession in 2019 and 2020,” he said.

Dovish comments by Fed chairman Powell in January and hopes for a resolution of the US-China trade dispute have pushed “valuations and volatility back to levels which we would consider to be fair”.

The US stock market is still reflecting the recovery in corporate earnings since the financial crisis, and “judging by the ratio of S&P 500 equity prices to after-tax profits, the market is currently valued at close to the historical average”, Tayler said.

He pointed out that since 1945, after-tax profits of US companies have increased 7.5% a year, while S&P 500 stock prices have risen by 7.3%.

However, he believes European equities should continue to trade at discounts “given the challenging economic environment and Brexit uncertainty”.

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