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    January 2018 | GSAM Connect

    2018 EM Equity Outlook

    In 2017, Emerging Market Equities have returned +37%, significantly outperforming US and Developed Market Equities, which returned +21% and +22% respectively1 – this marks the strongest absolute and relative performance in eight years. Looking to 2018, we believe Emerging Markets could be in the early stages of a multi-year recovery underpinned by 1) growth acceleration 2) earnings revival and 3) attractive valuations.

    Growth Acceleration

    Economic momentum in emerging market (EM) countries has been accelerating and becoming more synchronized. Coming off the lows of the Taper Tantrum episode in 20132, EM economies have boasted a more supportive macro backdrop. Years of currency adjustments have culminated in healthier current account balances (a country’s balance of trade in goods and services + net income from abroad + net transfer payments from abroad), record low inflation differentials relative to developed markets (DM), undervalued currencies and reaccelerated GDP growth. The synchronized recovery in GDP growth across the EM universe since 2016 has reversed the trend of a narrowing real GDP growth differential between emerging and developed markets, and IMF forecasts point to a likely widening of the spread at least until 2022. As shown in the chart below, such a rebound in momentum has historically correlated with a multi-year structural outperformance of EM equities vs DM.

    EM vs DM relative equity performance has historically correlated with EM vs DM GDP growth premium

    Source: IMF World Economic Outlook, GSAM as of December 2017.

    In addition, the long-term drivers of EM growth have shifted from commodities to consumption and technology, which are more sustainable in our view. After peaking at 40% of the EM equity universe in 2008, commodity sectors now comprise less than 15%, while technology and consumer sectors together make up more than 40%3 (see EM and the Commodity Conundrum).

    Earnings Revival

    Supportive macro fundamentals have fed into EM earnings, which have been recovering from a very low base. Return on equity (ROE)4 has been contributing positively to EM dollar total returns for the first time since 2011, and virtually all of the pick-up has been a result of growing margins and profitability. Furthermore, earnings momentum has turned positive for the first time since 2011 as MSCI EM reported earnings beat consensus estimates, prompting sell-side analysts to upgrade their 2018 forecasts. We believe we could be entering a synchronized multi-year cyclical recovery in earnings.

    Attractive Valuations

    MSCI EM price-earnings ratio (P/E)5 is currently trading at a roughly 30% discount to the S&P 500, cheaper than historical average discount of 15%6. Following years of EM underperformance, global investors remain under-allocated to EM7. Industry flows have been significant and accelerating – there has been $47.7B of net inflows into EM equity MFs and ETFs from US investors in 2017. We believe capital flows may continue given the universal under-allocation.

    Investment Implications

    Given our constructive outlook, we continue to encourage investors to build a strategic exposure to the EM asset class. However, while we see reason for optimism, we do caution investors around the limitations and risks of investing in standard EM equity indices. Specifically, the MSCI EM index only captures roughly 800 stocks out of the total 6,000+ in the investable universe. Within this already constrained universe, the index concentrates capital in structurally more impaired areas, such as state-owned enterprises (SOEs) which tend to have weak corporate governance and comprises roughly 25% of MSCI EM Index.

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    ABOUT THE AUTHOR

    Katherine Bordlemay

    Katherine Bordlemay

    Vice President, Fundamental Equity, Client portfolio Manager,, GSAM
    Luke Barrs

    Luke Barrs

    Emerging Markets Specialist, Fundamental Equity Client Portfolio Management,, Goldman Sachs Asset Management

    RELATED INSIGHTS

    January 2018 | GSAM Connect
    2018 EM Equity Outlook

    In 2017, Emerging Market Equities have returned +37%, significantly outperforming US and Developed Market Equities, which returned +21% and +22% respectively – this marks the strongest absolute and relative performance in eight years. Looking to 2018, we believe Emerging Markets could be in the early stages of a multi-year recovery underpinned by 1) growth acceleration 2) earnings revival and 3) attractive valuations.

    Emerging Markets

    The Emerging Market landscape has changed significantly over the last few decades. This evolution has created a broader set of opportunities for investors.