Geoffrey Dennis is head of global emerging markets strategy for UBS Investment Bank, a role he has held for more than three years. Prior to that, he was global emerging markets strategist for Citigroup for 14 years.
ETF.com: Why have emerging market equities risen so sharply this year after several years of underperformance?
Geoffrey Dennis: Emerging markets began to rally in late January last year. That's when the bottom was. We started the year very badly last year, so we were already in a 13% hole by the third week of January. We also had a pullback after the U.S. election, which was a surprise, and led people to pull money out of EM equities and put money into U.S. equities.
We had a lot of volatility last year, which meant the full year only had a gain of 8.5%. But the really important story is how much we came off of the bottom. We had a pretty good rally for essentially 11 months of last year, and now we've gone a bit further.
You have to break it up between what initially was the driver of the rally and what's become the driver lately. Initially, the driver was the rebound in commodity prices, the fall in the dollar, and the improvement in sentiment towards the global economy.
On the other hand, what's driving EM higher this year is the earnings story. We have this wonderful database that we call GEM Inc., and that database is giving us 26% earnings-per-share growth for 2017 in dollar terms. That would be the highest earnings growth number since 2010.
Last year, earnings growth in emerging markets was about 8 to 10%, which is very similar to the return for EM equities. Prior to that, between 2011 to 2015, you had a five-year period where earnings growth was very negative. That had a lot to do with collapsing commodity prices and a rising dollar. The dollar plays a tremendous role in EM; I've always argued that.
After five years of terrible performance, we're finally starting to see an improvement in profitability measures for the emerging markets.
ETF.com: There's been a lot of talk about how emerging market equities are cheap in terms of valuation. Do you agree?
Dennis: What's happened is that EM is up 15% this year, and the valuations have not moved, and that's because the earnings upgrades have been very significant.
However, EM today is trading between 12x and 12.5x forward earnings, compared to the long-term average of 11. It's not cheap historically, although it's cheap against the developed world.The high for this particular cycle—if you go all the way back to 2010/2011—is around 13x forward earnings. EM equities are expensive, but they're not as expensive as you might think by looking at how much markets have gone up this year, and that's because the earnings story has been strong.
The most interesting and more compelling story vis-a-vis valuations is versus the developed markets. We're sitting at about a 25% discount on a forward P/E basis to developed markets, and that's smack in line with the long-term average.
ETF.com: Are you bullish on emerging market equities right now?
Dennis: Yes. One of the reasons we're bullish on EM, and have been bullish this year—although they will eventually pause and pull back a little bit—is because global financial market conditions are extremely benign.
As some of the excitement over the reflation trade and a pickup in the U.S. economy began to fade—due to the challenges that President Trump faces in terms of getting fiscal policy through Congress, etc. You've seen bond yields in the U.S. stabilize at a fairly low rate. We expect them to end the year where we are now, at 2.4% on the 10-year yield.
You have also seen the dollar drifting slightly lower, particularly after the French election ended. We tend to think that low bond yields and a flat-to-lower dollar are helpful for EM. Because what happens then is investors stretch for yield; they look for markets where they can generate some yield and markets where they might see currencies that are rising and interest rates coming down. Brazil and Russia are good examples of that.
ETF.com: How much upside do you see in emerging market equities?
Dennis: We are actually above our formal year-end target, but 7% away from our upside target. That upside target is associated with benign global financial market conditions, low bond yields, low dollar, good earnings, strong inflows, etc. All of that is coming through, so it's a very valid upside target to talk about.
ETF.com: Can you talk about the strong inflows you're seeing?
Dennis: The trough of the flow story was the middle of last year. From March 2013 to the middle of 2016, we lost $155 billion from EM equity funds. Since then, we've gained around $30 billion, of which $20 billion has come in this year. Therefore, we've recouped only about 20% of the money that went out.
Retail money is getting interested in emerging markets again, but they still have a long way to go—that's what that is telling you.
My view is that the flows do not drive the markets, the markets drive the flows. Thus, you clearly need markets to continue to do well for that retail money to come in and validate that improvement. But on the assumption that we continue to do what we're doing at the moment—which is gradually move higher—a lot more money can still come in.
ETF.com: Which individual emerging market countries do see as having the strongest investment case right now?
Dennis: In terms of big markets, our overweights currently are South Korea, India, Russia, and Brazil. In terms of small markets, we're overweight Hungary, Peru and Colombia.
Contact Sumit Roy at firstname.lastname@example.org.
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