Emerging Market (EM) equities returned 9.2 percent as of 16 February 2017, the second strongest start to the year (US Dollar price performance). The strongest was in 2012, which it returned 14.2 percent.

Emerging equities’ US Dollar outperformance against global equities is the longest streak (11.7 percent over 280 trading days) since the Global Financial Crisis recovery period back in 2009/2010 (71 percent over 507 trading days). This overshadows the past seven rallies after a bear market in relative performance.

EM_vs_DM

According to Credit Suisse’s research, the analyst team believes that this is going to be the start of EMs outperformance against global equities. Here are five reasons why CS is bullish on EMs:

1. Steadily improving absolute and developed markets-relative margins

Profit margins have only improved by a meagre 40 basis points from its 17-year low during mid-2015. Moreover, value creation (return on equity less cost of equity) declined since mid-2011, only to start recovering and stabilising over the past few months.

Thus, CS believes that the recovery in EM profit margins has room for upside. More importantly, CS believes that the relative margin outlook for EMs relative to Developed Markets (DMs) is improving.

CS identifies three primary macroeconomic drivers for the progression of EM net profit margins: commodity prices, industrial production growth and productivity relative to wages.

Commodity prices

EM commodities sector currently represents a record low of 15 percent of MSCI EM index weight as low commodity prices led to fall in market value of commodity equities. As price of commodity recovers, EM commodities sector will also rebound, leading to higher valuation in EM indexes.

Industrial production growth

Net profit margins are pro-cyclical. As the overall emerging markets (and indeed global) business cycle improves, profit margins will improve in tandem.

Productivity relative to wages

Profit margins expands whenever growth in productivity outpaces wage growth. Productivity growth is finally higher than real wage growth after almost a decade for countries such as China, Brazil and Russia. As such, costs are lower for companies operating in EM.

2. Low currency valuation signals additional forex gains

In February 2016, investors were offered the buying opportunity of the century for EM currencies. Sine the 1997 Asian Financial Crisis, the GDP-weighted deviation from Price Parity (PPP) (excluding China) has never reached 60 percent, the level recorded in February 2016.

CS thinks that there is still room for appreciation for EM currencies. Should investors invest in EM equities or indexes, their return will include EM gains on top of the performance of EM equities or indexes.

3. GDP growth momentum back with EMs

Based on IMF estimates, the real GDP growth for EM against Developed Markets (DMs) would likely see structural acceleration from 2017 to 2021 – the first time in the past six years. To put simply, EMs are going to outperform DMs in terms of real GDP growth.

According to CS, the difference in real GDP growth has been an indicator of significant long-run correlation with relative equity market performance between EMs and DMs.

4. Low absolute and relative valuation (against historical and DM)

Absolute and DM-relative valuations are pointing towards an attractive entry point for EMs. CS pointed out that “EM equities are currently trading on a 12-month forward consensus PE multiple of 12.0x.” While this is in line with the 20-year average discount, it still has a 27-percent discount relative to DMs.

Moreover, the current EM PB multiple of 1.6x represents a 12-percent discount to its 20-year average. It is also 31 percent cheaper than DMs (the 20-year average discount is <23 percent) while offering similar ROE to developed markets.

5. Funds are turning their attention to EMs

Global funds have been underexposed to EMs as DMs have been outperforming in the past few years. As such, global funds are now seeing record-low level of exposure to the region over the past decade or so.

The positioning of hedge funds is slowly skewing towards accumulating EM equities relative to historical levels of net exposure. Thus, CS sees opportunities in EMs as global funds start to significantly accumulate EM equities.

Investors Takeaway: consider EM ETFs for exposure to EMs

CS recommends an overweight stance on EMs in a global equities portfolio. While bottom-up stock picks will allow investors to pick out EM equities that can outperform the market, bottom-up analysis of EM equities will require a lot of due diligence effort from investors due to the relative lack of coverage on EMs. Investors can consider several EM index ETFs as a top-down approach to have exposure to EM equities in their portfolio.

EM ETFs that give retail investors exposure: LYX MSCI EM MKT (H1N); DBX MSCI EM MKT (J0M); DBX MSCI EM ASIA (J0N); LYX EM LATAM (H1O)

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