Weekly Market Commentary
EM EARNINGS: BEGINNING TO EMERGE
Burt White Chief Investment Officer, LPL Financial
Matthew E. Peterson Chief Wealth Strategist, LPL Financial
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
By nature, emerging markets (EM) have greater risks, but they also have attractive attributes relative to developed foreign markets. For most markets, earnings have been stagnant while valuations—what investors are willing to pay for those earnings—have increased. In contrast, emerging markets are beginning to see earnings actually increase, albeit modestly. Initially, EM earnings growth was driven by commodity related sectors, but has broadened out, most importantly to include financial stocks. Furthermore, valuations in EM have not experienced the same expansion as other markets. As the earnings picture is souring for developed foreign markets, represented by the MSCI EAFE Index, overall, these developments increase the relative attractiveness of EM stocks.
IMPROVEMENT FOR EM EARNINGS
Given that the global financial markets have been in an earnings recession, emerging markets have experienced both earnings growth and improved expectations for future earnings growth. Admittedly, this growth is modest in both respects, but it is in stark contrast to prolonged earnings weakness in Europe [Figure 1]. EM earnings rose 1.3% year over year in the second quarter of 2016, a gain made more significant because at the beginning of the quarter, expectations were for a 6% earnings decline. More importantly, whereas 2017 earnings forecasts for the EAFE Index have declined over the past five months, expectations for EM are essentially unchanged. The fact that EM earnings have grown, and have exceeded expectations, has created greater confidence in forecasts. The poor performance in developed overseas markets has forced the market to lower expectations for the future.
The source of earnings growth is also telling, and shows the contrasts between developed and emerging economies. Earlier in the year, we saw EM earnings growth largely in commodity-related companies, as prices of not only energy, but also copper, iron ore, gold, and other commodities rallied after the sharp decline in late 2015 and early 2016. However, commodities no longer dominate the EM stock universe. In March 2011, commodity stocks represented nearly 40% of the index; today, energy and materials together only comprise 13.4% of the index. However, commodity-related stocks still “punch above their weight” by affecting stocks in other sectors, and entire national economies for countries like Brazil and Russia are heavily tied to commodity prices.
Today, financial stocks are the largest sector in both the MSCI EM and EAFE Indexes, at 26.5% and 19.2%, respectively. As has been well documented, the negative interest rate environment across the developed world has affected earnings and the performance of financial stocks. However, negative rates are a developed market phenomenon only; emerging countries tend to have much higher interest rates. In fact, the farther a country is removed from the global economic mainstream, the higher its interest rates tend to be. For example, export-dependent countries like South Korea and Taiwan have very low, though still positive, rates at 1.25% and 1.375%, respectively; while countries like China and India are at 4.35% and 6.5%. Rates are even higher in less politically stable countries, like Russia, where the central bank just cut rates to 10%, and Brazil, where short-term rates are 14.5%.
We can see the impact of low rates on financial earnings. Second quarter 2016 earnings for the developed world financial sector (defined by the MSCI EAFE Index) declined -11.6%. Equally, if not more important, expectations for earnings for the rest of 2016 and for 2017 have been reduced. At the end of March 2016 (before any first quarter earnings were released), financial sector earnings for the year were expected to be at. Currently, consensus expectations are for financial sector earnings to decline -9.8% for the year. The outlook for developed market financials has become even gloomier. In contrast, earnings for financial companies in EM actually grew by 2.7% during the second quarter. While not much, it is certainly much better than in developed markets. Furthermore, expectations for financial company earnings for the rest of the year really have not changed from March 31 to today. The market is expecting financial earnings growth of just over 14% for 2016.
VALUATIONS EMERGE AS ATTRACTIVE
Earnings growth is important, but so is what investors are willing to pay for earnings. Low interest rates globally have encouraged investors to buy stocks seeking greater total returns, and increasingly seek income from dividend-paying stocks rather than from bonds. As noted above, EM interest rates have not had the same magnitude of decline; in some markets, rates remain quite high. This is one reason that EM valuations have not expanded as rapidly as the same measures for the U.S. and EAFE [Figure 2]. Globally, we see price-to-earnings ratios (PE) generally follow each other across the regions. This makes sense, despite regional differences; all stock markets operate in a world that became increasingly globalized. However, valuations for both the U.S. and EAFE expanded rapidly, partially because of the cumulative impact of the Fed’s third quantitative easing program that began in September 2012 and further interest rate reductions by the European Central Bank (ECB) in May 2013. Equity markets in the U.S. rallied, but with PE expansion as a significant part of that rally. The reverse happened in EM. Stock prices fell and valuations for the asset class contracted. We believe this divergence may represent an opportunity, but only if earnings continue to increase.
LPL Research uses a combination of fundamentals, like earnings growth, valuations, and technical factors in evaluating investment opportunities. While this commentary focused mostly on EM, several previous commentaries have focused on Europe, which is the primary component of the EAFE Index. We can use the activity in the European markets to show how these factors combine. Valuations have increased in Europe, though not to the same extent as for U.S. equities. Earnings in developed overseas markets have declined and expectations continue to fall. The technicals are telling us that the market has real questions about European fundamentals. Overall, Europe continues to lag, as nearly all European country stock markets are down in 2016, with the Financial Times Stock Exchange (FTSE, the primary U.K. stock market gauge) the surprising outperformer. Technically, the EURO STOXX 50 has been in a downtrend for more than 15 years. Focusing on more recent market activity [Figure 3], the EURO STOXX 50 ran into firm resistance from a trend line going back to the April 2015 peak. We can see in this example how the three components of our process can reinforce each other, and in this case reinforce our caution with respect to Europe and developed international equities in general.
Emerging markets have seen earnings increase and future expectations remain stable. This improvement has occurred across many sectors, including the important financial sector. Combined with relatively attractive valuations, we believe opportunities exist in EM for suitable investors, though strength in these markets will likely depend on continued earnings growth. We can see how disappointing earnings can impact performance, and therefore the stock charts and technicals, by looking at recent technical weakness in European stocks. — —
Thank you to Ryan Detrick for his contributions to this report.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market. All investing involves risk including loss of principal.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The MSCI EAFE Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises the MSCI country indexes that represent developed markets outside of North America: Europe, Australasia, and the Far East.
The MSCI Emerging Markets Index captures large and mid cap representation across 23 emerging markets (EM) countries. With 822 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The EURO STOXX 50 Index is a blue-chip index for the Eurozone, which covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
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Prior Weekly Market Commentaries:
- December 11 2017: CORPORATE BEIGE BOOK: UPBEAT AS EXPECTED
- December 4 2017: 2018 STOCK MARKET OUTLOOK: DOUBLE-DIGIT RETURNS?
- November 20 2017: HIGHLIGHTS FROM ANOTHER STRONG EARNINGS SEASON
- November 12 2017: TRUMP’S FIRST YEAR
- November 6 2017: MLP WEAKNESS APPEARS OVERDONEETS
- October 30 2017: WHAT MIGHT SCARE MARKETS
- October 23 2017: FIVE REASONS TO TAKE A LOOK AT JAPAN
- October 16 2017: THE 1987 CRASH: A NOT SO HAPPY ANNIVERSARY
- October 9 2017: THIRD QUARTER 2017 EARNINGS PREVIEW: SLOWER BUT STILL SOLID
- October 2 2017: MARKETS BUYING INTO TAX REFORM
- September 25 2017: THE BULL MARKET APPEARS ALIVE AND WELL
- September 18 2017: UPDATE ON GROWTH AND VALUE STOCKS
- September 11 2017: STRONG EUROPEAN EARNINGS ARE KEEPING EUROPE CHEAP
- September 5 2017: PUTTING THE NORTH KOREAN THREAT INTO PERSPECTIVE
- August 28 2017: CORPORATE BEIGE BOOK: UPBEAT AS EXPECTED
- August 21 2017: TAKING A LITTLE RISK OFF THE TABLE
- August 14 2017: BOTTOM LINE: IMPRESSIVE EARNINGS SEASON
- August 7 2017: BUY THE DIP? WHAT DIP?
- July 31 2017: IS POLICY SKEPTICISM CREATING A SMALL CAP OPPORTUNITY?
- July 24 2017: TAX REFORM PIVOT?
- July 17 2017: GLOBAL SUMMER EARNINGS: SIZZLE OR FIZZLE?
- July 10 2017: SECOND QUARTER 2017 EARNINGS PREVIEW: Q1 A TOUGH ACT TO FOLLOW
- June 26 2017: A TECHNICAL CHECK-IN: THE GLOBAL BULL LOOKS STRONG
- June 19 2017: MIDYEAR OUTLOOK 2017: BUSINESS FUNDAMENTALS BACK AT THE CONTROLS
- June 12 2017: HURDLING OVERSEAS EARNINGS-WHAT DO THE FORECASTS TELL US?
- June 5 2017: MASTER LIMITED PARTNERSHIP MORE GOING ON THAN OIL PRICE
- May 30 2017: CORPORATE BEIGE BOOK: IT KEEPS GETTING BETTER
- May 22 2017: FOCUS ON FUNDAMENTALS
- May 15 2017: EARNINGS UPDATE: RAISING THE BAR
- May 8 2017: FIVE REASONS NOT TO SELL IN MAY
- May 1 2017: REFLECTING ON NASDAQ 6,000
- April 24 2017: EUROPE ENTERS THE TOUR DE FRANCE
- April 17 2017: WHICH BREAKS FIRST, STOCK PRICES OR UNCERTAINTY?
- April 10 2017: FIRST QUARTER 2017 EARNINGS PREVIEW: DOUBLE DIGITS?
- April 3 2017: CHECKING IN ON SOME TRUMP TRADES
- March 27 2017: THE STOCK MARKET’S FINAL FOUR FACTORS
- March 20 2017: WILL THIS SIXTEEN BE SWEET?
- March 13 2017: HOW MUCH IS LEFT IN THE TANK?
- March 6 2017: CORPORATE BEIGE BOOK: BETTER SENTIMENT AND LOTS OF TAX TALK
- February 27 2017: TIPTOE THROUGH THE TULIPS AND OTHER EUROPEAN OFFERINGS
- February 21 2017: EARNINGS UPDATE: FIVE OBSERVATIONS
- February 13 2017: REAL ESTATE OVERVIEW: ALL ABOUT THE CYCLES
- February 6 2017: TAKING STOCK OF TECHNICALS AND SENTIMENT
- January 30 2017: IS THERE STILL VALUE IN VALUE?
- January 23 2017: INTERNATIONAL STOCKS WE LOOK EAST TO JAPAN
- January 17 2017: IS SMALL CAP STRENGTH SUSTAINABLE?
- January 9 2017: FOURTH QUARTER 2016 EARNINGS PREVIEW: LOOKS LIKE ANOTHER GOOD ONE
- January 3 2017: 2017 STOCK MARKET OUTLOOK: GEARS ARE TURNING, BUT PARTS MAY NEED GREASE
- December 19 2016: A LOOK BACK AT 2016 HITS AND MISSES
- December 12 2016: CAN’T STOCKS AND BOND YIELDS JUST GET ALONG?
- December 5 2016: IRRATIONAL EXUBERANCE PART TWO?