Emerging markets (EM) have made their strongest start to a year since 2006, with the MSCI EM Index jumping 3.67% in this year’s first week of trading. This early updraft follows a 37% gain (in USD terms) for the EM equities benchmark last year, its best annual performance in nine years.
The rapid pace of gains will likely moderate, in our view. But we remain positive on EM equities, since we see many of the supportive factors behind the rally still in place:
- EM economies will continue to benefit from synchronized global growth. Global GDP expanded 3.8% last year, by our estimates, and is expected to grow 3.9% this year. The UBS GDP-weighted EM manufacturing PMI strengthened to 52.6 in December, with all regions indicating expansion.
- We believe growth in corporate profits will drive the bulk of returns in the coming year. While top-line growth may no longer accelerate much, we see further upside from better profitability: return on equity (ROE) improved to 11.4% as of last November from a trough of 10.2% last May. Overall, EM earnings growth will likely moderate relative to last year but still expand by around 10–12%, in our view.
- Valuations are not stretched. The MSCI EM Index is trading at 13.9x its 12-month-trailing price-to-earnings ratio, one standard deviation above the 10-year average, but at a 24% discount to developed markets.
So we expect a total return rate for EM equities in the mid-teen range this year. We remain overweight global equities, of which around 11% are made up of EM stocks.
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