Introduction
Facing plenty of negative headlines, markets have turned decidedly risk-averse over the past few weeks. With the worst of the pandemic seemingly behind us, recovering demand and limited supply triggered multi-decade highs in inflation readings in most developed markets. As central banks were just starting to increase interest rates, the Russian invasion of Ukraine took the world by surprise, immediately sending commodity prices through the roof. With the likelihood of a long conflict now increasing, the war’s impact on Ukrainian and Russian crops should lead to additional food inflation, raising the risk of political instability. In this context, the tightening monetary policy in the US is now fuelling fears of stagflation, a particularly worrisome scenario for equities. In emerging markets, negative sentiment has been exacerbated by new regulatory developments and slowing domestic consumption in China. Adding to the pressure, China is facing a recent Covid outbreak, further weighing on consumption.
While the picture looks grim, there might be reasons for some optimism around emerging-market equities.
Investors have unsurprisingly already reacted sharply, with risky assets being punished and major indices significantly off their highs: from the start of this year to 29 April, the MSCI World Index was down 13%, the Nasdaq Index declined 21% and the MSCI Emerging Markets Index lost 12%.
Yet, while the picture looks grim, there might be reasons for some optimism around emerging-market equities. Their relative valuation appears quite attractive, as investors may have overreacted to a perfect storm in China, and a potential economic stimulus from the government could have positive implications for the region.
A Perfect Storm in China
Emerging markets (‘EM’) have underperformed developed markets (‘DM’) in recent months.
However, it is interesting to notice that the EM underperformance has come mainly from China, while the relative strength of DM was mainly US-driven (Figure 1). In fact, the MSCI EM ex-China and World ex-US indices have performed roughly in line. In comparison, the MSCI China Index has underperformed the MSCI USA Index by 44 percentage points since January 2021. Within China, the offshore market has been the pain point, driving the negative sentiment since early 2021, contrasting with the onshore market that has only struggled since early 2022.
Figure 1: The Negative Sentiment in EM Equities is Mostly China Driven
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Source: Bloomberg; as of 29 April 2022. Rebased to 0 as at 1 January 2021.
We believe regulatory developments, driven by both the Chinese and US governments, can explain most of the underperformance of the China offshore market.
Since the last-minute suspension of Ant Group’s IPO in 2020, a series of anti-monopoly, data security and industry-specific regulations have been introduced in China, raising uncertainties about future earnings growth. The market turmoil triggered by this increasing pressure has bruised offshore investors disproportionally relative to their onshore counterparts, with most of the impacted companies listed offshore – in particular, those leveraging the Variable Interest Entity (‘VIE’) structure. (You can read ‘Offshore, But Not Off the Regulatory Radar’ for a detailed analysis).
Meanwhile, a Covid outbreak in mainland China, which led to a lockdown on portions of the country, is further weighing on already slowing domestic consumption. In April, the Chinese government pledged to support its economy, potentially alleviating some of the recent negative sentiment.
Separately, in the US, the Securities and Exchange Commission (‘SEC’) has also increased the pressure on US-listed Chinese securities, demanding more accounting transparency as a condition of remaining listed in the US. Analysing price returns for different categories of US-listed Chinese securities tends to indicate that investors have mainly been trading around this regulatory risk in recent months, indicating a potential dislocation between pricing and fundamentals. It is hard to predict how the situation will end, but regulators in both countries are discussing details around a potential audit deal, with China recently indicating hopes of seeing it signed in 2022. We believe resolving the dispute would trigger a sharp rally in the listings at risk.
Analysts May be Worried, But Earnings Growth is Holding Up
The historical perspective clearly points to upside potential in China.
Although the level of consensus forecasts has proved resilient so far, we do see weakness in analysts’ earnings revisions, which is a better reflection of the market sentiment. Having said that, large divergences exist between EM ex-China, China and VIEs (Figure 2). Analysts are neutral in EM ex-China but bearish on VIEs, in line with recent market returns. Revisions are now similar to the levels seen in 2015 after the market crashed in China, the US-China trade dispute in 2018-2019, and the beginning of the Covid-19 pandemic in 2020. While fundamentals can always worsen, the historical perspective clearly points to upside potential in China.
Figure 2: Analyst Sentiment is Most Negative for VIEs
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Source: Man Numeric, Bloomberg; as of 29 April 2022.
Contrasting this picture of analyst revisions, earnings growth seems to be holding up in China, in line with growth expectations for the MSCI World (Figure 3). Again indicating that the recent market meltdown could have been driven more by negative sentiment than deterioration in the fundamentals, earnings growth offers a reassuring view of fundamentals in China and the broader EM universe.
Figure 3: Earnings Growth is Holding Up
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Source: Man Numeric, Bloomberg; as of 29 April 2022.
Relative EM Valuation Looks Attractive
EMs have rarely appeared this attractive in the past 13 years.
From a valuation perspective, both China and broader EMs now appear quite attractive compared with developed markets (Figure 4). The forward price-to-earnings (‘P/E’) discounts of the MSCI EM and China indices have increased since 2021 as investors withdrew from Chinese securities. Aside from the crisis during the early period of Covid-19 outbreak in 2020, EMs have rarely appeared this attractive in the past 13 years, trading at a 29% discount to the MSCI World as of 29 April 2022. Similarly, the MSCI China only looked more attractive on a relative basis in 2014-15, which preceded an extended market rally.
Figure 4: EM and China Relative Valuations
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Source: MSCI, Bloomberg, Man Numeric; as of 29 April 2022.
Conclusion
There’s no denying the economic landscape is likely to remain challenging for emerging markets in the coming months. However, in light of the fundamentals and relative valuation we have highlighted, the region could now offer meaningful upside potential, in our view.
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