A shakeout in emerging market (EM) equities has created value in a world where good quality value is scarce. EM equities do face increased tail risks such as tightening financial conditions and ripples from U.S.-China trade tensions. Yet we believe current valuations and strong earnings growth offer investors ample compensation for these risks.

This year’s weakness in EM equities has opened up a disconnect between prices and fundamentals. EM equities have recovered somewhat in recent weeks, yet are still down almost 15% from January peaks. This has left valuations at 11.3 times forward earnings, a shade below their five-year average, as shown in the chart above. Yet forward earnings-per-share (EPS) growth estimates of 13.4% are running well ahead of the average over the same period. EM EPS growth forecasts for both this year and 2019 have been revised up since the start of the 2018, implying the outlook for EM stocks may be brighter than current valuations suggest.

Finding value

Our base case of steady global growth, led by the U.S. and China, a gradual pace of Federal Reserve rate increases and double-digit corporate earnings growth provides a favorable backdrop for markets. Yet uncertainty around the outlook has increased. Escalating trade tensions and fears of U.S. overheating, along with rising interest rates, have contributed to a stronger U.S. dollar and tightening financial conditions. This has hit EM assets the hardest and created pockets of value, in our view.

EM earnings momentum is solid and increasingly broad-based. The median earnings growth for stocks in the MSCI EM Index for 2018 and 2019 is forecast to be 10.1% and 13.6%, respectively. EM earnings growth was disproportionately concentrated in the tech sector in 2017, but eight of 11 sectors are forecast to deliver double-digit  earnings growth in 2018. Several other trends underpinning the appeal of EM equities are intact. Our BlackRock Macro GPS points to the global expansion carrying on through 2018. China has shifted from a tightening stance to explicit stimulus–both fiscal and monetary–to stave off any sharp slowdown.

The dollar’s moves have delivered a double-whammy to EM equities this year. Tighter financial conditions stemming from a stronger dollar and higher U.S. rates have hurt assets in countries dependent on dollar funding the hardest, such as in Latin America.

Depreciating EM currencies have dented the appeal of EM equities for dollar-based investors who generally take unhedged positions. There are some signs that pressures from a firmer dollar are abating: Latin American stocks are up 13% from their recent trough and broader EM equity outflows have slowed in recent weeks. Yet EM equities are much more than a dollar play. The EM equity selloff is set against a backdrop of strong fundamentals: Attractive valuations, robust earnings growth and the highest return on equity in four years. Any de-escalation in trade tensions would brighten beaten-down sentiment.

Bottom line

We still like EM equities, with a preference for Asia. Potential further tightening in financial conditions calls for greater selectivity.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog

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