• Having lagged other markets post-GFC, emerging market equities will benefit from price stability in commodities. Strong earnings growth provides support for higher valuations.
• US rate hikes and China macro dynamics are threats, but emerging markets have previously performed well in periods of rising rates, and China will continue to benefit from supply side reform and a focus on education and entrepreneurship.
• The emerging market universe is sufficiently diverse and robust for stock pickers to find exciting opportunities and we expect earnings to drive markets over time.

Emerging market equities, as measured by the MSCI Emerging Markets Index, delivered solid gains in 2017, beating the S&P 500 for the first time since 2012. As investors, we remain focused on our bottom-up approach. However, in this paper, we offer a few bigger picture thoughts on 2018, including areas of opportunity and concern.

While emerging markets (EM) were able to ride out the immediate aftermath of the financial meltdown in 2008-9, they were dogged by a long and severe decline in oil and other commodity prices after 2012. From the end of 2012 through last year, the MSCI Emerging Markets Index lagged the S&P 500 Index by more than 80 percentage points, even after returning 37% in 2017. The point of maximum pessimism was reached in January 2016, when many commodity prices fell to unsustainably low levels. This floor provided a good starting point for the EM universe, as historically (rightly or wrongly), EM equities and EM currency performance have been highly correlated with the commodity complex. Commodity prices began to recover in 2017, and we currently see price stability in commodities (and expectations for a long drawn-out recovery) supporting EM equities.

Figure 1: Emerging Markets rebounded in 2017

Source: S&P Dow Jones; MSCI; Columbia Threadneedle Investments; Bloomberg Barclays. S&P 500 index, total return. MSCI Emerging Markets Index total return, gross. 31 December, 2012 = 100.

VALUATIONS ARE JUSTIFIED

Some investors have expressed concern about valuations in EM. Price/book and price/earnings levels are slightly above their historical means, but there are other factors to consider.

First, starting in mid-2016, we saw an end to a major earnings recession in EM that brought margins from 11% for the universe in 2011 to 6% in 2016 (source: FactSet; Columbia Threadneedle Investments.) The 'death by a thousand cuts' earnings revision cycle that we witnessed for most of the decade seems to be over; 2017 saw very strong upward earnings revisions and next fiscal year expectations have been stable so far. We believe this will continue in 2018, with earnings growth supporting higher valuations.

We also believe multiples for the universe should trade at a premium to historical levels because the composition of the universe has seen a great deal of positive change. Ten years ago, the biggest names in this universe were companies such as Gazprom, Petrobras, and PetroChina - big, cyclical, state-owned companies. Today, the biggest names are Alibaba, Tencent, and Samsung, which are higher quality companies delivering a higher return on invested capital (ROIC). These companies deserve a much higher multiple.

Figure 2: Variation in MSCI EM Index Composition 31.12.2007 v. 31.12.2017

Source: Columbia Threadneedle Investments and FactSet.

The relative multiple is also something that needs to be considered. In the current low-interest-rate world, multiples have expanded significantly (as they should) in developed markets. While EM multiples have expanded as well, the asset class is still trading at about a 30% discount to the S&P 500.

KEY DRIVERS OF GROWTH

We believe there are several strong drivers of continued strength in EM performance in 2018. Earnings growth, as mentioned above, continues to improve. This growth is driven in part by much greater capital discipline from companies: cost-cutting, right-sizing of balance sheets, etc. Greater operating efficiency plus pent-up demand in these economies is also a big driver in the earnings story.

We are also seeing improvement in EM GDP growth, which bodes well for equities. This broad trend is occurring in markets such as China, but also in places starting from a much lower GDP base such as India, Indonesia and the Philippines. In Russia, for example, falling inflation, falling interest rates, cheap valuations and an improving economy provide a strong backdrop for stocks. In India, we have seen solid structural reforms driving greater local participation in equity markets.

An additional driver is that many investors (in our view) are under-allocated to EM, either due to a lack of rebalancing, negative sentiment or just plain neglect. Among those who may be underinvested in the asset class are emerging markets residents themselves, but this is changing rapidly, not just in India as cited above. We are seeing much greater local participation in domestic equity markets (just as we are seeing significant growth in local debt markets). These local investors are less likely to run for the exits if the FOMC raises the overnight rate, for example, which may translate to greater stability in EM markets.

THREATS TO OUR VIEW

There are three topics of concern that are commonly raised as threats to the EM recovery story: US rate hikes, China macro dynamics and geopolitical risks. We will address the first two - the geopolitical risks are generally well known to investors and their outcomes require analysis and speculation beyond the scope of this piece.

US RATE HIKES AND US DOLLAR STRENGTH

We don't believe that there is a significant risk from higher rates and a stronger US dollar. While these factors may be a negative for the asset class, they would not be a disaster by any means. The Fragile Five (Turkey, Brazil, India, South Africa, Indonesia) is no more. Over the last seven years, the consensus view was that a strong US dollar would lead to a crisis in EM. However, the expansion of local debt markets has helped to change this dynamic, as companies can more easily borrow in their own currency. While Turkey is currently the market of greatest concern, EM as a whole is in a much stronger place today than in the past: economies have stabilised, current account balances are healthy, and foreign exchange rates are largely in balance.

When considering interest rates, it is important to understand the rationale for the hikes. In the current environment, rates are rising because the global economy is stronger, which can be very positive for emerging markets. If you look at past interest rate cycles, emerging markets have performed quite well in periods of rising rates if the underlying factor is a stronger global economy. We believe that there is a lot of fear in the markets around the impact of rates, perhaps because of the taper tantrum in 2013, when emerging markets significantly underperformed simply with the prospect of higher interest rates - but EM is in a much less vulnerable position today than in 2013.

CHINA MACRO DYNAMICS

Concern that debt to GDP has grown too rapidly in China - that incremental debt was producing very little growth and any policy error could be magnified - is an oft-cited threat for emerging markets equities.

This is a fair concern on the surface and certainly had significance in the past. However, there are a few things we would point out on the subject:

• Supply side reform is helping "old China" industries; high costs and excess capacity are being cut, helping many industries return to being cash flow positive. Importantly, this cash flow is not being used for new capital expenditures to grow capacity, but instead is being used to pay down debt. This leads to relief for the banking system, where there is concern about non-performing loans being under-reported.
• Housing inventory (which had been fuelled by growth in lending) has been greatly reduced. Raw data can obscure the picture as older housing, which is obsolete and eventually torn down, is included in the inventory count.

We have long argued that there are really two economies in China, the old industrial China and the new services-oriented China. Again, many market pundits look at China statistics on the whole and are unable to differentiate between the tech-driven, entrepreneurial coastal regions and inner, oldeconomy China. In the years since 2001, China has surpassed the UK and Germany in the number of international patent applications per year, and is narrowing the gap with Japan. If China were to pass Japan, the country would be second, behind the US. This growth in patent applications highlights China's transformation over the last few generations and its increased focus on education and entrepreneurship.

Even with potential threats to the EM recovery story, the market is sufficiently diverse and robust for stock pickers to find opportunity. When we look at our bottom-up universe, we are excited about the earnings stories, and it is earnings that will drive markets over time. At the beginning of 2017, the expectation for EM equity earnings growth was 15%, and it ended the year somewhere between 25% and 30%. We expect a similar dynamic of upward revision in 2018.

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