A new dawn for emerging equities

Emerging-market equities spent much of this decade treading water, but since early 2016 they have been making up for lost time.

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Developing economies are building from a more solid foundation

Emerging-market equities spent much of this decade treading water, but since early 2016 they have been making up for lost time. The benchmark MSCI Emerging Markets index has jumped by 60% since January 2016, and the outlook remains favourable. Indeed, we could be seeing a "new dawn" for the asset class, according to fund-management group Barings.

Growth in developing countries has rebounded after a slowdown caused by the end of the commodities boom, recessions in Brazil and Russia, and lacklustre growth in industrialised countries. Now, with the global economy finally accelerating, many developing countries have achieved their best growth rates since 2012; the PMI gauge of manufacturing activity across the asset class is near a six-year high.

A rise in inflation, partly caused by a slump in emerging-market currencies a few years ago, has been overcome. As central banks have squeezed out inflation, they have gained scope to cut interest rates, stimulating growth. Brazil is a prime example, notes Craig Mellow in Barron's. Inflation has dwindled to a record low and the main interest rate has halved to 7%. All this has given corporate profits a welcome boost after five years of shrinkage. Bank of America Merrill Lynch is pencilling in a 22% increase in earnings per share for the MSCI index this year; its 2018 forecast is a gain of 13%. Valuations, meanwhile, are still below the historical average.

This is a positive backdrop, but emerging markets will always be at least partly beholden to events in the developed world. "Bulls note that growth depends less on exports to [Europe and the US] these days and more on China and internal markets," says Mellow. "But arguments like this have meant little during previous global shifts to risk-off psychology." Emerging markets are unlikely to decouple if there is a global sell-off.

A key headwind will be higher interest rates in the US, which, along with the resulting rise in the US dollar, always draw money away from riskier assets. Unexpectedly fast rate rises caused by the return of inflation (see below) could shake confidence in developing countries, while the Trump administration could damage trade-dependent countries' prospects if it resorts to protectionism.

Still, higher US rates should not have too much of a knock-on effect. Most emerging-market debt is denominated in local currencies these days, not dollars, so there won't be much of a jump in debt-servicing costs. Provided the global economy can keep going, emerging markets should, too. Concentrating on countries with big domestic markets and solid long-term prospects such as India and the Philippines may help investors stomach the inevitable volatility.

American workers will get their pay rise

America's labour market has shrugged off two months of hurricane disruptions and resumed normal service, says Sho Chandra on Bloomberg: that of "solid hiring but tepid wage gains". Payrolls grew by an unexpectedly strong 228,000 in November. The unemployment rate stayed at 4.1%, the lowest since late 2000. But average hourly earnings rose by a mere 0.2% last month, an annual rate of 2.5%.

To investors, this is a Goldilocks scenario: employment growth is solid, but wages are not rising fast enough to give inflation much of a kick, so the US Federal Reserve need only raise interest rates very slowly indeed. Capital Economics notes the markets have only pencilled in one rate hike next year.

However, markets shouldn't be too relaxed, says Justin Lahart in The Wall Street Journal. One of the mysteries of this cycle is that wages have failed to take off even though unemployment is far below levels that in the past have foreshadowed rapid wage growth. But there must be a point where wages begin to rise more rapidly, and we are now probably not too far off it.

The U-6 measure of unemployment, a broad gauge that includes discouraged workers (those who have given up seeking work) and those who say they would work if jobs were available, has fallen to the lowest level since 2006. The pace of monthly payroll gains has been falling slightly since 2015, "an indication that companies really are having a harder time filling spots".

Another interesting straw in the wind, adds Randall Forsyth in Barron's, is that the New York Fed's Underlying Inflation Gauge, deemed more of a leading indicator than many other inflation measures, has already jumped to almost 3%. Capital Economics reckons interest rates could rise four times next year which would give doveish markets a nasty surprise.

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