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An attractive turn for emerging markets in 2019?

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      By Gary Greenberg, Portfolio Manager, Hermes Investment Management, Calvert Subadvisor

      London - Emerging-market strength is broader - and better - than the crisis-stricken economies that dominated the news in 2018. But after a year of tumult, how will emerging markets fare in 2019? In our view, the strongest headwinds facing emerging markets have abated and many measures of valuation are attractive relative to developed markets.

      In 2018, emerging markets faced several stiff headwinds, including competition from the United States, where tax cuts resulted in a tremendous boost to corporate earnings. In our view, this year should be different. Tax-cut euphoria is wearing off in the U.S., and we believe emerging markets are on track for better earnings growth and return-on-equity than many developed markets.

      Calvert Blog 2-15-19A

      Headwinds lifting

      Several key macroeconomic and political pressures have lifted in part or completely. Trade war tensions between the U.S. and China appear to have eased. Although tensions remain, we are increasingly confident that China and the U.S. will go for some type of trade "win." The U.S. dollar is stabilizing in response to the Federal Reserve's dovish stance in 2019. As of today, oil prices are lower, with the Brent down by about 30% (in USD terms) since its October 2018 highs, reducing pressures on oil-importing countries. A number of key elections have taken place, notably in Turkey, Mexico and Brazil, alleviating some political - and policy - uncertainty.

      Despite the loud headlines, emerging-market stress has, in fact, largely been confined to countries with weak fundamentals or political instability, such as Turkey and Argentina (which together represent less than 1% of the MSCI Emerging Markets Index). We see reasonable growth, low interest rates and sensible economic policies in place for most countries in the Index, indicating the business environment is more robust than the headlines suggest.

      Valuations attractive

      Looking across several key measures of valuation, emerging markets look attractive compared to developed markets. Emerging-market profitability has recovered, estimated return-on-equity is competitive, and price-to-book and valuations appear cheap on a historical basis. Emerging-market small- and midcap stocks, for example, are close to two standard deviations below their 10-year historical averages, per Bloomberg.

      Calvert Blog 2-15-19b

      One less traditional measure we think is telling is free cash flow, which is a measure that focuses on the profitability of a company's business operations.1 Approaching 6%, free cash flow is near the highest it's been in 20 years, and compares favorably to interest rates in most parts of the world.

      Lingering concerns

      Of course, challenges remain. We view the unpredictability of U.S. trade policies, whether with China or Russia, as an ongoing concern. However, we are increasingly confident that the U.S. and China will go for some type of trade "win." Slowing Chinese growth and reliance on the dollar are still headwinds; however, emerging-market foreign exchange reserves have improved. Although unlikely to have a huge impact on emerging markets, Brexit's uncertain outcome is weighing on markets.

      We believe the current negative sentiment around emerging markets means many investors are likely underweight to this asset class. In our view, many emerging-market companies are seeing robust business prospects, but are trading at depressed valuations. With the shift in global market conditions from 2018, we see real value in emerging markets over the next 12 months, and for years to come.

      Bottom line: Many of the stiff headwinds facing emerging markets in 2018 have lifted. Offering investors more attractive growth, earnings and valuation prospects than developed markets, we see real value in this asset class potentially over the next 12 months, and for years to come.