Although there have been local factors at work in some of the disappointing growth stories above (for example, sharply lower investment in India and a weak technology sector in Taiwan), there are also two important common threads:
• First, several EM economies – Brazil and Korea are the best examples – have been suffering an EM version (i.e. a milder version) of the debt deleveraging and sharp slowdown in credit growth story seen in many industrial countries;
• Second, the weaker Chinese economy has led to sharply lower import growth, reducing exports from countries such as Korea, Taiwan and Brazil. Weak exports (including to Europe) have led David Lubin, Citi’s Chief Global EM Economist, to argue recently (1) that the growth model for emerging markets is now changing — away from exports and towards increased domestic demand growth.
The unexpected weakness of EM growth in 2012 is important for equity investors as it has been a contributor to virtually flat corporate earnings in 2012 — again a story of disappointed expectations. Over the past twelve months, the consensus EPS forecast in emerging markets for 2012 has collapsed from +9.5% to just +0.6%. The largest downgrades have been in Latin America (+7.1% to -14%), while EMEA forecasts are also now negative for last year (-2.5%). Consensus still calls for positive 2012 EPS growth in Asia of 7.5%. As with the GDP forecasts, there are major country divergences, with sharp earnings declines now expected for 2012 in Brazil, Russia, Chile and Poland and close to zero growth in China and Taiwan. These downgrades largely reflect sharply weaker commodity/cyclical and technology earnings. Meanwhile, robust domestic demand and the high market weight of domestic growth sectors have allowed earnings in markets like Mexico, India, Thailand and Turkey to grow at double-digit rates in 2012, including growth of over 27% in Mexico itself.
EM equities had a good, if volatile, year in 2012, with a dollar-adjusted gain of 15%. However, given virtually no earnings growth, this implies a significant re-rating of the asset class over the past 12 months. We estimate that EM equities trade on 12-12.5x current year earnings (a slight premium to long-term averages), although they also trade at 10.5-11x forward year earnings which is a 5-10% discount to their long-term historical average; in any event, the EM valuation gap versus history has declined over the past year as earnings growth has stalled.
With ample liquidity in global financial markets driven by quantitative easing in developed economies and significant monetary easing over recent months in emerging markets, the above valuation analysis suggests that the most important driver of EM equities in 2013 will be ‘growth’ – of economies and earnings. Will EM economies rebound, as our economists expect – with GDP growth forecast to rise to 5.3% – and will earnings growth follow? If they do not, it is unlikely that EM equities will be able to re-rate to the same extent as they did in 2012, which will cap the potential advance of the markets.
There is an important aside. The weakness of earnings in emerging markets in 2012 has largely been, in our view, a cyclical issue. However, we have also argued extensively in recent reports (2) that there are, nonetheless, secular forces at work now which have reduced the long-term growth rate of EM earnings to essentially DM rates, despite much stronger GDP growth in the region. EM earnings growth is being held down by factors including high wage inflation, the impact of high trend commodity prices on earnings (in a part of the world that is more industrial-based and therefore more commodity-intensive than in the service-oriented developed world) and the goal of many EM companies (especially in Asia) of sales- rather than profit- maximization. The result is that EM companies have a margin problem compared to DM companies that is holding down long-term earnings growth in the asset class. This will not prevent periods of outperformance of EM equities – it just means these will only come when the EM valuation discount versus DM markets opens up sufficiently, as currently at 10-15%.
The year to come should again be a solid one for EM equities, with projected gains of around 10% — slightly below 2012. We advise investors to add to ‘risk’ stocks, for the long-term, and sell ‘quality’ names. However, given the above commentary, the ability of EM equities to record another year of double-digit gains will depend, above all, on whether the expected rebound in earnings growth materializes. We look for EM earnings to rise by around 13% in 2013, supported by both a sharp earnings rebound in markets where there was weakness in 2012 (i.e., Brazil, China and Taiwan), and ongoing robust EPS growth in markets where domestic demand should stay strong. To play this, we currently favor cyclical sectors such as Consumer Discretionary, Financials and, in the near-term, Materials over defensive and expensive sectors such as Consumer Staples and Health Care.
1. See “Emerging Markets: To a New Growth Model” in Global Economic Outlook and Strategy, David Lubin, 26 November 2012.
2. See, most notably, “What is Wrong with Emerging Markets?” Global Emerging Markets Strategy , Geoffrey Dennis, 17 May 2012.
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The main culprits have been some of the biggest economies in the emerging world. Twelve months ago, we had expected Taiwan to grow by 4% in 2012; we now forecast it will come in at just 1%. Other sharp 2012 forecast declines have been seen for Brazil (3.4% to 0.9%), India (7% to 5.4%), Korea (3.4% to 2.3%) and South Africa (2.9% to 2.2%). The same is also true in China, where despite clear recent evidence that the growth slowdown is finally ending; over the past year, our 2012 forecast for growth has fallen to 7.7% from 8.4%. What makes these disappointments such a puzzle is that several other EM economies such as Indonesia and Turkey have seen 2012 growth in line with prior forecasts, while others including Chile, Mexico, Peru and Russia have even exceeded initial growth expectations.
