Higher Earnings Spur Emerging Markets
05/27/2009 11:06 am EST
Alec Young, equity strategist at Standard & Poor’s, says stronger earnings growth for emerging-market companies point to higher stock prices in some regions.
We believe significant year-to-date emerging market (EM) equity outperformance is being driven by healthier earnings per share (EPS) revision trends.
The number of positive revisions divided by negative revisions [in the] MSCI Emerging Markets index recently rose to 0.71 versus only 0.42 for the Standard & Poor’s 500 index and 0.41 for the MSCI EAFE Index.
In light of the higher secular economic growth rates of emerging markets, analysts expect EM equities to experience a faster EPS recovery as the global economy gradually improves.
At the regional level, reflecting healthier macroeconomic backdrops characterized by aggressive domestic stimulus and central bank easing, emerging Asia and Latin America sport higher 2009 EPS revision ratios than emerging Europe and the Middle East & Africa (EMEA), where we believe high external debt continues to weigh on economic prospects.
Emerging Asia and Latin America recently saw their 2009 EPS revision ratios rise to 0.80 and 0.61, compared to EMEA’s weaker reading of only 0.37, which is roughly in line with its February cycle low of 0.34. Regional revision trends are correlating with equity performance, as EMEA badly lags both emerging Asia and Latin America [in the] year to date.
EPS revision trends are also highly correlated with equity performance at the country level: Taiwan, South Korea, India, Canada, China, and Brazil have higher EPS revision ratios and also are 2009’s best-performing major markets.
Conversely, reflecting the likelihood of weaker economic recoveries, analysts have been slower to upwardly revise their 2009 earnings expectations for laggards such as Japan, Europe, and the United States.
We believe emerging market equities represent a leveraged play on global growth. The asset class tends to suffer more when growth contracts and appreciate more as it recovers. EM equities declined 63.7% from October 2007 to March 9th, versus a smaller 56.8% decline for the S&P 500.
Similarly, the MSCI EM Index rallied 47.3% since March 9th, compared to a smaller 34.2% gain for the S&P 500. This higher volatility is reflected in a high EM beta of 1.43 relative to the S&P 500.
By contrast, the MSCI EAFE index, a leading developed international equity benchmark, sports a lower 1.13 beta vs. the S&P 500.
Over the short term, we expect some consolidation of the recent explosive emerging market equity rally, as we think the fundamentals need time to catch up with surging stock performance.
The current emerging market equity valuation of 13.5x consensus estimated 2009 EPS represents fair value over the near term. However, as the global economy continues to recover over the next 12 months, we expect continued upward EPS revisions, modest P/E expansion, and the asset class’s higher beta to fuel [higher returns than] developed market equities.