This year is proving a very good one for emerging markets (EM) after years of lagging behind the S&P 500 (see figure 1 below).
Capital flows being good for EM equities (and bonds) have also been helpful for EM currencies, including the rand, and so the JSE, while it usually performs in line with the EM when measured in US dollars, has offered well above average EM returns to the offshore investor on the JSE this year (see Figure 2 below). As we have explained in earlier reports, strength in EM equities and bonds has a consistently favourable influence on the exchange value of the rand and most other EM currencies.
The underperformance of EM equities since 2011 has been accompanied- by weak earnings – earnings per share that have lagged well behind those generated by the S&P 500 Index. As may be seen in figure 3, S&P 500 earnings measured in US dollars compared to EM or JSE earnings in early 2010 , are more than 80% ahead, when measured in US dollars. The underperformance of EM equities has been highly consistent with this underperformance, as has the strength of the S&P been consistent with the impressive recovery in S&P earnings.
It should however be noted below in Figure 4 that EM and JSE earnings, having suffered a severe decline in 2015 led by lower commodity prices, appear to have reached a cyclical trough and are now increasing from their low base, while S&P earnings are also now pointing higher, after declining since early 2015. This revival in average earnings must be regarded as helpful for equity valuations generally, especially in a world of very low interest rates. That EM and S&P share prices moves have been highly correlated in 2016 is consistent with a similarly higher trajectory for earnings, especially should recent trends be sustained, as has been indicated.
The similar path of JSE earnings and that of the EM average – of which the JSE contributes only a small part, about 8% – should be recognised. It goes a long way to explain the similar direction of the EM Index and that of the JSE, when measured in US dollars. The JSE behaves as an average EM equity market because JSE earnings compare very well with the EM average. This is because JSE-listed companies, including industrial companies, are highly exposed to the global economy, even more than the SA economy.
In figure 5 below, we compare the average prices investors have been paying for average earnings. As may be seen, investors in the S&P Index have enjoyed a significant increase in the average P/E multiples and seen the Index re-rate when compared to the multiples attached to EM earnings. Such reactions are entirely consistent with impressive past performance, especially when accompanied by low interest rates that surely add to the present value of future earnings or cash flows expected. But the fact that S&P earnings have become expensive by the standards of the past and EM earnings can be acquired significantly cheaper than S&P earnings, will have attracted interest in EM compnaies, especially when the global economic and earnings prospects appear to be improving.
One sign of an improved economic state can be found in the Citibank surprise Index calculated for the 10 largest economies. As we show below in figure 6, the high frequency economic data has become much more encouraging. Expectations are being surprised on the upside. These more positive surprises are clearly helping to lift the equity markets. The economic news has been improving, surprisingly so, and global equity markets are responding accordingly. The strength in equities is well explained by economic fundamentals, especially so when the threat of higher interest rates seems so distant. 15 August 2016
