It’s not too late to ride the emerging-market equities bandwagon. From economic expansion to corporate earnings and capital expenditure, everything points to their overtaking developed peers through the middle of next year, according to Credit Suisse Group AG.
A benign trajectory for profit growth should spur the MSCI Emerging Markets Index about 8.3 percent higher from current levels, reaching 1150 by the end of June, according to strategists at the Swiss bank. The gauge has already notched an 18-percentage point increase over its developed counterpart over the past year and a half.
"We are regularly asked by global equity and multi-asset investors if it is too late to engage in emerging market equities," Credit Suisse analysts Alexander Redman and Arun Sai wrote in a report published Friday. "We argue that the answer is no; it is not too late. This view is predicated on what we believe to be compelling evidence which indicates performance attributes to be mid- rather than late-cycle."
Credit Suisse strategists analyzed 10 emerging-market stock metrics and found that only two show signs of mid-to-late cycle behavior.
Developing-economy equity funds posted $1.6 billion of outflows the week ending Aug. 16, the biggest 5-day withdrawal since late December, according to EPFR data, as geopolitical tensions and concerns over U.S. policy paralysis drove risk aversion around the world.
The broader capital-flow picture is bullish, however. Heavy positioning in U.S. and European stocks this year is spurring fears over frothy valuations, while investors have firepower to increase exposure to developing-economy assets in the months ahead.
Global equity funds still have a 400 basis points active underweight stance on EM stocks relative to the MSCI All Country World Index, according to Credit Suisse. That follows three years of withdrawals from dedicated emerging-market funds between 2013 and 2015, followed by a flat 2016.
After six years of profit-growth disappointments, earnings results since June have outperformed consensus estimates made 12 months earlier, for the first time since 2011.
Emerging-market equities are poised for further gains as the business cycle -- commodity prices, industrial production, and productivity gains -- is still in the summer of its expansion, according to the bank. It projects a further 40 basis points of margin expansion this year alone.
What’s more, non-financial net profit margins remain below the two-decade average of 7.7 percent and significantly below the 2008 peak of 10.5 percent. That suggests the market return on equity has "considerably" more room to run. Credit Suisse recommends overweight positioning in China, South Korea, Russia, Indonesia, Malaysia and Poland, and an underweight stance toward Taiwan, India, South Africa, Mexico, Thailand and Chile.
Over the next four years, the International Monetary Fund projects emerging-market growth outperformance to accelerate, following years of successive downgrades to consensus forecasts. That, combined with a projected decline in interest rates adjusted for inflation, should also add juice to the rally.
The big risk to watch is the outsized role of technology stocks in driving this year’s EM rally, bringing the sustainability of gains into question in a tech downturn.
"Emerging market equities seem back in vogue," the strategists wrote. "Nonetheless, in both absolute and relative U.S. dollar performance terms the current bull market phase for emerging equities does not appear stretched either in terms of magnitude or duration."
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