Emerging markets have faced a perfect storm recently, writes JPMAM's Emily Whiting.
Disappointing economic growth, the commodity collapse, and some political chaos had sent many investors fleeing for calmer waters. But, over the first quarter of 2016 in particular, emerging market and Asia Pacific ex Japan equities led the rebound in global equities, mainly driven by a positive contribution from foreign exchange where emerging market currencies bounced back, in direct inverse to a weakening of the US dollar.
At the same time, EM equities saw multiple re-ratings, which had not been seen for some time. This budding recovery in sentiment coincides with valuations at historic lows.
Nevertheless, questions remain about the sustainability of the recent rally, which has yet to be underpinned by stronger fundamentals, causing investors to question whether this is just a temporary bounce or the beginning of what some may call a breakout.
Unfortunately, investors have faced a number of false dawns before.
Throughout the EM bear market of the past four years, there have been six instances where EMs have risen more than 10% in absolute terms, only to later continue their secular decline.
Markets have also seen four episodes in this period where EM equities have outperformed global equities by five percentage points, similar to the magnitudes markets have seen year-to-date.
All of this suggests the recent turnaround could be seen as a risk rally, and there may not be enough evidence in itself to justify a breakout.
In the near term, much depends on the path of the US dollar. If the dollar has peaked and is now weakening, then there is potential for a breakout in EM equities. But if the dollar's rise has merely paused, we will likely look back at the rally and say it was a powerful bounce, but not the upturn investors have been waiting for.
The ultimate catalyst, however, for a sustainable recovery in EM equities will be a pick-up in earnings. Some EM markets and companies are better positioned than others to benefit from an improving global backdrop, and investors need to navigate carefully to clasp the favourable trade winds and avoid the undertow.
Emily Whiting is client portfolio manager on J.P. Morgan Asset Management's emerging market and Asia Pacific team
Bull Points
• If the US dollar has now peaked, this should have a positive effect on commodity prices and earnings
• Valuations remain attractive
Bear Points
• A pick-up in earnings still needs to be evident for a rebound in EM equities to be sustainable
• China is becoming more risky over time
