Mid-Year Outlook: The Resurgence of Emerging Markets

The first half of 2017 has been bright for emerging markets, generally speaking. My colleagues Stephen Dover, chief investment officer of Templeton Emerging Markets Group, Chetan Sehgal, director of Global Emerging Markets/Small-Cap Strategies and Carlos Hardenberg, senior vice president, director of Frontier Markets Strategies, examine factors boosting sentiment this year and point to some themes and sectors we are excited about in this space going forward.

Emerging-market (EM) equities (as represented by the MSCI Emerging Markets Index) have extended their 2016 recovery. In the first half of 2017, the MSCI EM Index returned 18.60%, compared with an 11.02% gain in the MSCI World Index.1

The strong start to the year reflects an improved macroeconomic backdrop following a period of currency and commodity price adjustments and widespread political change.

The factors many investors have historically found attractive about the asset class have come back into play, including stronger earnings growth and robust consumer trends.

While areas of risk remain, our view is that we are still in the early innings of the emerging-market earnings growth upturn. We also believe valuations and sentiment continue to be supportive.

Even in regions that are still going through adjustment and rebalancing, we see more visible signs of robust underlying economic conditions. Positive factors include low debt, stabilizing commodity markets, reduced currency volatility and improving consumer confidence. The implementation of reforms in many countries has also been further driving market confidence.

Importantly, EM corporate earnings growth hit an inflection point in 2016 after several years of decline, due in part to weaker commodity prices and slowing growth in China. Earnings growth now appears to be rebounding. Emerging-market corporations’ capital allocation and cost efficiency also have been improving, which we believe should support profit margins and lift return on equity.

As of the end of June 2017, the MSCI Emerging Markets Index’s earnings growth was 13.08%, approximately 53% higher than that of the MSCI World Index.2 (See chart below)

Valuations also appear supportive of investing in EM equity markets generally, in our view. As of the end of June 2017, the price-to-earnings (P/E) ratio for the MSCI Emerging Markets Index was 14.60, while the S&P 500 Index P/E ratio was 21.40 and the MSCI World Index 19.86.3

Taking a long-term view, the structural investment case for emerging markets continues to center around demographics (including a rising middle class) and domestic consumption. We think it’s also important to recognize that there have also been fundamental shifts in the corporate landscape.

Emerging markets are more diversified than they were a decade ago. The asset class has undergone a significant transformation from the often plain-vanilla business models of the past. Older models tended to focus on infrastructure, telecommunications, classic banking and commodity-related businesses. Today, we see a new generation of highly innovative companies which are moving into much higher value-added production processes, or are on the cutting edge of world-class technology leadership.