Trade deal announced
After months of elevated tensions between the US and China, a Phase 1 trade agreement was announced on 13 December. From the US side, the deal includes a partial rollback of previously imposed tariffs and a suspension of tariffs slated to go into place on 15 December. From the Chinese side, the deal includes promises to increase agricultural purchases and implement structural reforms related to intellectual property, technology transfers, and other areas. We find the deal particularly encouraging as it marks the first time the US has agreed to roll back tariffs, with plans for further rollbacks as opposed to delays. But it's important to note that some details are lacking, including the conditions for further tariff rollbacks, and that the risk remains of a deal not being signed in the beginning of January.
With an improved outlook for tariffs, we believe we may have seen "peak tariffs," removing one major downside risk from 2020. In emerging markets, where economies are heavily dependent on trade, the lower risk should flow through to improved sentiment and eventually economic activity. Our current growth forecast for 2020 expects the GDP growth differential between emerging and developed markets to widen from its recent plateau of around 2.5% toward its long-term historical average of around 3.5%. An improving growth differential in favor of developing economies has been a key driver for emerging market equity outperformance, as shown in Fig. 1.
Overweight EM equities
In light of the Phase 1 trade agreement, we have moved emerging market equities to overweight. Emerging market equities have underperformed most developed markets in 2019 because of lackluster economic data, muted earnings growth, a strong US dollar given the negative impact of tariffs, and drawn-out Sino-US trade tensions that dragged down business activity and investor sentiment. However, with a partial deal having been reached, the backdrop for emerging market fundamentals, which have already started to stabilize particularly in Asia, now provide slight tailwinds instead of headwinds for profit growth in the region.
Fig. 1: This could be the beginning of another EM bull cycle
Performance of MSCI EM versus MSCI World; GDP growth differential between EM and DM(in %)
Improving earnings outlook
We believe emerging market earnings are set to recover in 2020 from a very depressed base in 2019 (consensus expects –3% to +1.5% earnings growth). Across emerging markets, we have been seeing a shifting momentum from negative to positive revisions in 12-month earnings outlooks. More importantly, leading indicators including composite PMIs as well as currencies indicate earnings upside in 2020. We therefore believe the risks to our earnings growth forecast (9.8% for 2020) are skewed to the upside especially in Asia and Latin America.
Fig. 2: A less uncertain global trade environment should securea favorable earnings outlook for emerging markets
2020 consensus earnings growth: MSCI EM vs. MSCI World
Valuations are reasonable
Emerging market equities' 12-month-forward price-to-earnings (P/E) ratio stands at 12.7x, about 15% higher than its historical average but supported by its valuation discount relative to developed markets and potential upside to earnings. We believe a pickup in earnings growth will be the main driver of performance and should support the current rating. Relative to developed markets, we find emerging markets' valuation attractive, at an unjustified discount of 25% despite its superior earnings growth prospect in 2020. The underlying 10% underperformance of emerging market equities versus developed markets this year—along with cumulative fund outflows from the asset class (around USD 20bn vs. inflows of USD 60bn to emerging market bonds) and the low share of emerging market equities in global mutual funds’ assets under management (7% vs. 9% historically)—leaves room for these stocks to catch up, propelled also by the better-than-expected trade agreement and the risk-on environment following the likely avoidance of a hard Brexit. Our target level for MSCI Emerging Markets in the next six months is 1,110, with room for upside.
Fig. 3: EM equities are attractively valued relative to DM peers
EM-DM valuation (12-month price-to-earnings ratio) discount
Xingchen Yu, Emerging Markets Strategist Americas, UBS Financial Services Inc. (UBS FS)
Brennan Azevedo, CFA, Emerging Markets Associate Americas, UBS Financial Services Inc. (UBS FS)
Corinne de Boursetty, CFA, Strategist, UBS AG