Emerging-market equities: what are we waiting for?

Increasing regulation in China across many industries is hitting the outlook for profits, and the uncertainty over the extent and duration of the crackdown means investors require an additional discount on top of their future earnings base case.

At the same time, economic growth has slowed in tandem with the Delta outbreak, and we expect an underwhelming rebound in the fourth quarter as temporary regional lockdowns are likely to be required for some time. Then there’s the spillover from Evergrande’s* problems to the important property sector. These are all drivers behind our below-consensus growth forecasts.

But equity markets have reacted – a lot.

The correction in Chinese equities (H-shares, not A-shares) is now one of the biggest in recent history. The HSCEI index is around 30% off its February peak, making it the third largest drawdown over the past decade. Broader emerging-market equities have also been affected, having trailed developed markets by 20%, the third-largest underperformance over the past 15 years.

Sentiment has turned very bearish. In an extreme reversal, emerging-market equities have gone from almost everyone’s favourite long at the start of the year – based on sell-side outlooks and investor surveys – to being the least popular in the latest fund manager survey since their low in 2016.

Valuations paint a similar picture. Relative to developed markets, emerging-market equities are as cheap across many multiples as they have been in well over 10 years. Some of that clearly reflects falling earnings expectations, but earnings estimates have some way further to fall before catching up with what prices have already reflected.

Crisis and opportunity

Some of this sounds like a bull case in the making, but regulatory uncertainty and our below-consensus growth outlook are some of the factors holding us back – for now, at least.

Nevertheless, we are watching a number of potential catalysts and signposts that could change our position. These include:

The bottom line is that emerging markets and China equities are becoming more interesting in some ways but, given our macro views, we believe it’s too early to buy.

*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.