30 Sep 2021 3 min read

Emerging-market equities: what are we waiting for?

By Lars Kreckel

It’s easy to be bearish on emerging-market equities amid the double trouble from regulatory and growth risks – but does this make it an opportune moment to buy on a valuation or contrarian basis?

 

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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:

President Xi or the Chinese government making a commitment to the private sector – and tech companies in particular. We have seen some of this already and it could help reduce the tail risk on earnings.

Decreased sensitivity to regulatory news flow. We have seen some evidence of this in the tech space, but the price reaction to new sectors being targeted – such as casinos – remains severe.

A-shares selling off. The pain has so far been concentrated in H-shares. A-shares joining in the correction would in our view be a sign of markets pricing the growth slowdown as much as the regulation theme, and a sign of domestic capitulation.

A larger-than-expected policy response to a slowdown. We expect policymakers to be slower than in the past in responding to stumbling growth, but evidence to the contrary would be a very positive catalyst.

Indications that our growth forecasts are too pessimistic and growth rebounds faster than we expect.

Vaccination convergence. Emerging-market vaccinations are catching up with developed markets.

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.

Lars Kreckel

Global Equity Strategist

Lars is not your average German: he owns the house he lives in, has two children and drives Japanese cars (one electric). Maybe that’s also why he covers equities rather than bonds?

Lars Kreckel