Posted inEmerging Markets

The case for a selective return to EM equities

Few asset classes underperformed as much as emerging equities last year. The MSCI Emerging Markets Index, for example, fell by about 17%, compared to the MSCI World Index, which finished the year down by close to 10%.

Companies involved in the smartphone supply chain, the auto sector and domestic consumption, in particular, took a hammering.

Shoaib Zafar, a global equity analyst at SYZ Asset Management, argues that the share price slump combined with potential catalysts – including a US-China trade settlement and slowing US Federal Reserve rate hikes – now make emerging equities look attractive at current levels.

“With emerging equities trading at a discount of about 25% to global markets, current valuations are possibly pricing in the challenges facing emerging markets, but not potential solutions,” Zadar said.

Moreover, he argued, since the last full-fledged financial crisis, most emerging economies have learned important lessons.

“They are much more diversified now than two decades ago, and many have accumulated sizeable reserves. Their central banks are more credible, and states like China have learned how to tame inflation by steering fiscal policy,” he said.

Russian valuations

Among promising investment opportunities within the emerging world at the present time, according to Zafar, are Russian equities, which are trading at fairly cheap valuations.

“The 5x forward price-earnings ratio represents a hefty discount to the historic average and to the current emerging market average of 12x,” he said.

“As an oil exporter, Russia has some of the lowest breakeven oil production costs in the world and major oil companies like Rosneft, Lukoil and Tatneft are well placed to maintain and grow oil output at a price below $30 per barrel. So even though oil has been weak recently, this is unlikely to result in higher volatility in earnings for the sector, which accounts for slightly more than 30% of Russia’s GDP and 70% of its exports.”

China debt risks

In Chinese equities, meanwhile, a trade settlement with the US could spur an immediate rebound in sectors including financials and consumer discretionary.

Zafar said SYZ remained cautious about the high levels of debt in China and as a result recommended seeking out unlevered companies with more prudently managed balance sheets which can be found in a number of sectors.

“Growth names in consumer discretionary, such as Haier Electronics and Anta Sports, and defensive firms, such as Guangdong Investment, in utilities tick all the right boxes,” he said.

Brazilian banks

“In Brazil, the current focus has been on the market-friendly outcome of recent elections,” Zafar continued. “While there remains a delivery risk, given high expectations surrounding the new president – especially on the fiscal and pension reforms agenda – financial markets seem prepared to generously reward any positive outcomes.”

Brazil’s banks look set to benefit from increased economic activity and lending, and a fall in provision expenses over the past two years has supported bottom-line growth.

The country’s three largest banks – Banco do Brasil, Banco Bradesco and Itau Unibanco – are sitting on Common Equity Tier 1 (CET1) reserves comfortably in excess of the requirements for 2019.

Turkey and Pakistan

Turkish equities have also been recovering since the easing of sanctions imposed by the US. Further improvement in political stability and economic visibility could support both the lira and Turkish equities, which are trading at a 50% discount to their emerging market peers.

Recovery plays can be found in financial services (Turkiye Garanti Bankasi) and chemicals (Petkim Petrokimya Holding), Zafar said.

Finally, Pakistan has been making progress in terms of political and economic stability. The new government elected this year seems willing to take unpopular measures, such as increasing gas tariffs, to improve the economy. With the IMF’s help, and if promised fiscal reforms go ahead, the macroeconomic backdrop could quickly improve, leading to a possible rerating of the country’s equities, which are trading at a price-earnings ratio and 45% discount to the MSCI Emerging Market Index. “Firms involved in infrastructure development and financial services could become interesting opportunities as confidence improves,” Zafar added.

David Robinson

David Robinson is the editor of Expert Investor. He has 18 years’ experience as a business journalist and editor. In the past he has written for the Guardian newspaper and The Telegraph, and worked as...

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