Earnings propel emerging assets

The MSCI emerging market index has rebounded by more than 14 percent since November when the United States Federal Reserve paused interest rates increases and China rolled out targeted economic stimulus.

Gary Poon

Monday, April 15, 2019

The MSCI emerging market index has rebounded by more than 14 percent since November when the United States Federal Reserve paused interest rates increases and China rolled out targeted economic stimulus.

However, the index is still 13 percent below its highest recorded at the beginning of last year.

"This year, we have started to see the beginning of what I think should be a strong run for emerging markets. I think the assets have just begun to recover and there is a lot more room to run," says AllianceBernstein multi-asset solutions portfolio manager Morgan C. Harting.

He suggests three reasons.

The first reason is that companies' earnings growth is disconnected from their stock price.

In 2018, the earnings growth in emerging markets improved by 12 percent, while stock prices dropped by 15 percent, he explains.

"In these years, when the earnings are better than the stocks, the following year has consistently been better. In 2004, the stocks did not keep up with strong earnings and then you saw stronger stock returns in 2005. In 2008, the stocks did worse than earnings. It was in 2009, you saw better returns," he says. "That tends to mean that in 2019, the stock returns are going to be good."

Another reason is that the US dollar is strong and has reached an extreme level, which would benefit emerging markets.

Harting explains that American consumers have a lot of purchasing power and they can purchase lots of goods from emerging countries. Meanwhile, companies based in emerging countries have an advantage because their costs are denominated in a cheaper local currency.

Harting thinks it is unlikely the US dollar will continue to appreciate.

The third reason would be the growth advantage in emerging markets that is starting to widen.

The International Monetary Fund cut its outlook for 2019 and 2020 last week and said that advanced economies would "continue to slow gradually" into next year, while emerging economies would play a more positive role, led by an end to crisis conditions in Turkey and Argentina, and stabilization in the all-important Chinese growth rate.

The Emerging Markets Multi-Asset Portfolio, the fund that Harting manages, recorded 5.54 percent over 3 years annualized total return, and 3.48 percent over 5 years annualized total return. It outperformed 1.43 percent and 4.11 percent compared with the average return of same category funds respectively, according to Morningstar.

The fund held 73.59 percent of equities, 25.4 percent of fixed income and 1.01 percent of the short-term investment, as at January, 31. However, its average credit quality is BB-.

"Our fund has more active asset allocation. Some of the other funds in this space have more static allocation - may be 50 percent on bonds and 50 percent on stocks. I think that is too rigid," Harting says.

He says equity was only almost 65 percent at the end of last year and had risen to almost 80 percent over the past three months. He added Chinese A and H shares, Turkish stocks, and Brazilian stocks into the portfolio recently.

He believes Chinese stocks would benefit from stimulative policies and short-term interest rate cuts.

"China has both fiscal and credit stimulus. There is more money coming into the system, which should be supportive for risk assets. If you think of the last 10 years and why developed market equities have done so well, governments, central banks provided a lot of stimuli, and that was good for asset prices," Harting says.

"The short-term interest rates have been coming down in China and that is another source of liquidity support for the market. All of this is happening in the context of a period where earnings growth is still positive, and I think that is likely to be sustained. Also, investors are beginning to react."

China is the largest source of assets in the portfolio with 23.66 percent of total assets, followed by South Korea with 12.26 percent and Taiwan with 9.61 percent.

Alibaba Group, Samsung Electronics, and Tencent (0700) accounted for a total of 10.1 percent of assets, lower than the MSCI emerging market index of 13.03 percent.

The share price of Tencent has rebounded by more than 50 percent since October to about HK$390, but it is still 17 percent below the 2018 January historical high of HK$471.

"We are not as concentrated in some of the technology names like Alibaba and Tencent. Strictly speaking, they actually are not in the tech sector anymore. But we tend to focus on names where we have a high conviction from a fundamental basis," Harting says.

Tencent suffered a lot when China tightened regulations on gaming last year and beginning of this year, Harting says tech companies are facing more regulations, while Google and Facebook are also facing the same problem.

"Tencent already has seen some limits on new games. Some of the changes and rules that the Chinese government is making are related to young people and gaming. That is a role of government.

"I am happy to have large exposure to China. But the weight in China is not determined by MSCI for this portfolio. For investors who want to allow MSCI to determine their portfolio, they can buy a passive index fund."