In a double whammy for money managers, emerging-market stocks are underperforming but becoming more expensive.
The MSCI Emerging Markets Index has handed investors a loss, including reinvested dividends, of 7.5% in the past 12 months, compared with a 2.2% total return from the MSCI World Index. Yet bargain-hunting opportunities are rare among $17 trillion of beaten-down stocks in the developing world — their relative valuation to developed-nation equities has increased 3%age points toward the highest levels in six years.
The reason, in a nutshell, is falling earnings.
Corporate performance in emerging markets is slumping for a third successive quarter, straying further from analysts’ earnings estimates, which are themselves falling.
The average profit at companies of the MSCI emerging-markets gauge has slipped 3.9% in the past year, while it has increased 6.4% for firms in the developed-market index. The degree of this underperformance, at about 10%, resembles the amount developing-market stocks have lagged peers in advanced economies.
Analysts are taking note. They have reduced their average estimate for profit at emerging-market companies in the next 12 months by almost 12% in the past year, while they have raised the forecast for businesses in the developed world by 1.4%.
It is this dichotomy that makes emerging-market valuations surge relative to rich nations. The falling denominator makes the price-estimated earnings ratio look bigger and bigger. In other words, the P/E ratio of MSCI Emerging Markets Index is rising mainly for the wrong reason.
Given that stocks in China and Hong Kong account for 31% of the index, it’s safe to assume that they have contributed most to the drop in the earnings estimates. In fact, the dollar forecasts for the Shanghai Composite Index have declined 6.9% in the past 12 months, and those for the Hang Seng China Enterprises Index have plummeted 15%.
The trade war between the US and China has raised questions about the growth trajectory of the world’s second-largest economy and the demand outlook for commodity trade. With the International Monetary Fund cutting its projection for global growth, the case for riskier assets has weakened.
While the much-expected looser Federal Reserve policy can still rescue emerging-market earnings performance, for now, both reality and expectations are falling.
And that makes valuations a measure of increasing risk rather than reviving momentum.
© 2019 Bloomberg L.P.