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How to Navigate Emerging-Markets Equities

Currency stability, growth in emerging-markets economies and corporate earnings upgrades should be evaluated in stock buying considerations.

So far this year, there has been divergent performance across the emerging-markets equity asset class. Through the end of May, for example, Russia rebounded as one of the best performers, helped by some stability in oil prices and the cease-fire in Ukraine. The strong rally in China A shares has spilled over into the Hong Kong–listed market. Meanwhile, Brazil has struggled with huge declines on the back of currency weakness, bleak growth prospects and public protests dragging down the markets.

Although the overall asset class has been on a stellar run very recently, emerging-markets equities have faced serial headwinds over the past four years. Sentiment has been deteriorating as growth has disappointed relative to that of developed markets. The strength of the U.S. economy and currency, coupled with speculation that a looming U.S. interest rate rise might tighten emerging-markets liquidity, has not helped.

There are three potential catalysts that could determine whether the latest rally signifies a sustainable turnaround in emerging-markets performance. The first is currency stability, which may remain in question, given the current strength of the U.S. dollar and the Federal Reserve’s slow steps toward a rate rise. Emerging-markets economic growth also has to regain momentum, and earnings must recover from the multiyear disappointment that has led to the derating of the past few years. Although energy and materials are providing the most visible downgrades, expectations in dollar terms continue to be low across most sectors, with the exception of information technology. When the first two catalysts — currency stability and a pickup in growth — take hold, we can expect earnings upgrades to follow, which in turn should help to kick-start returns.

Ultimately, we at J.P. Morgan Asset Management would like to see emerging markets start performing on their own fundamentals again. For investors, major gaps among countries and companies in emerging markets in terms of development, policy, prospects and valuation make differentiation critical, underscoring the need for a selective approach to portfolio construction. Investors would do well to focus on quality businesses with multiyear growth potential that are not overvalued. Companies are benefiting from domestic demand in emerging markets, making consumer sectors and financials look attractive. In terms of country exposure, India and South Africa offer companies with strong prospects, good corporate governance and sustainable earnings growth.

Here are some key points we are taking into consideration on emerging-markets equities:

•Uncertainty has kept emerging-markets valuations attractively low for long-term investors with the patience to buy and hold. It’s interesting to see that today, given the initial phase of the quantitative easing–driven rally in Europe, European multiples have been pushed up such that emerging markets look cheaper than Europe on a fundamental price-earnings basis.

•Year to date, 25 global central banks have cut rates. This can create a very powerful stimulus effect.

•Macro growth forecasts for emerging markets have stabilized, albeit at modest levels. Emerging-markets earnings have continued to struggle, however, and estimate revisions have accelerated to the downside.

•S&P 500 performance has a direct relationship with U.S. dollar strength, whereas relative performance in emerging markets tends to have an inverse relationship with the dollar.

•In light of the U.S. dollar surge and risks arising from external debt within emerging markets, we are more concerned about micro risk than macro risk, given that currency reserves for the vast majority of emerging markets are high relative to short-term external debt.

Richard Titherington is chief investment officer and head of the emerging-markets equity team at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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