EM valuation remains attractive despite weak earnings forecast

by SHAZNI ONG/ pic credit: schroders.com

EMERGING market (EM) equities generated the second-highest total return in local currency terms driven by rising valuations despite earnings growth having been next to nothing, observed an international asset management company.

British multinational asset management company Schroders plc said the poor earnings growth is partly to be blamed on collapse in commodity prices and depressed global trade.

“Since the outbreak of Covid-19, markets have climbed a wall of worry, despite cuts to corporate earnings, forecasts and dividends.

“Increasing valuations have been the main engine of returns in all markets so far this year but looking back over the past five years, we find a different set of drivers,” Schroders research and analytics strategist Sean Markowicz (picture) said in a note yesterday.

Markowicz noted that US equities have generated the highest earnings growth of all markets shown, which investors have been rewarded with higher valuations.

“In this sense, the US had the best fundamental underpinning over the last five years. The UK and European markets have been driven by a combination of modest earnings growth and dividends.

“Yet, the market has failed to reflect these fundamentals in valuations, which have collapsed. Brexit fears, the US-China trade frictions, and the pandemic have all contributed to this decline over the past five years,” he said.

Although the US is not immune to any of these headwinds, Markowicz said its lower sensitivity to global trade and concentration of tech companies has meant that it has not been materially affected.

“(Meanwhile), Japanese markets achieved the lowest return. Earnings growth has been meagre while valuations have fallen against the backdrop of a sluggish economy,” he said.

Markowicz explained when investing in overseas markets, investors take on exposure to foreign currency movements.

“This can add to or detract from portfolio returns. Although this is excluded from the above analysis, it can sometimes have a material impact on equity investments abroad.

“For example, over the past five years, a weakening pound lowered UK equity returns for US dollar investors by 5% a year. By the same token, however, it lifted US equity returns by 5% for sterling investors,” he said.

Similarly, Markowicz viewed a strengthening dollar lowered EM equity returns by 2% for US dollar investors, while boosting US equity returns by 2% for EM investors.

“Currency returns are a zerosum game. Investors who wish to avoid such uncertainty can hedge their foreign currency holdings at a cost that is known in advance,” he added.

Looking ahead, Markowicz said previous one-time boosts to US earnings such as corporate tax cuts are unlikely to reoccur.

“In fact, we may even see this policy reversed if Joe Biden, the Democratic presidential nominee, gets elected to office in November. Without this underlying earnings tailwind, US equity valuations are vulnerable to a correction.

“EMs also appear to be on shaky ground, as valuations have been doing most of the heavy lifting for returns,” he said.

On the other hand, Markowicz observed markets such as mainland China, Taiwan and South Korea, which represent roughly 60% of the EMs index, have largely reopened their economies with minimal disruption, following several months of stringent lockdown measures.

“If this trend holds, a rebound in earnings could be on the cards. Dividends have provided a solid base for the UK and European equity returns, which have been supported by earnings growth.

“However, the global recession has forced many companies to drastically cut dividends by at least 20% or more, while analysts have cut long-term earnings forecasts,” he said.

Although this has removed a key layer of support for future returns, Markowicz opined much of this is already reflected in current valuations, which have room to recover.

“As for Japan, analysts are sanguine about corporate profits over the coming years, as expectations of a swift economic recovery have surged.

“For example, over the past month, the forecast for long-term earnings growth has almost tripled from roughly 4% to 11% a year.

“If investors have conviction in this profit recovery, the potential for positive contributions from all factors remains possible,” he said.