ANALYSIS-Profit squeeze hammering emerging equities
LONDON, March 8
LONDON, March 8 (Reuters) - Record high stocks? Currency surges? In the United States maybe, but across emerging markets, slowing economies and collapsing exports are hammering company profits far harder than in the seemingly hobbled West.
While world stocks have risen more than 5 percent already this year, led by Wall Street's surge to record highs, bourses from China to Brazil are flat to negative in dollar terms, unnerving those who fear a third year of stop-start performance.
To add insult to injury, most emerging market currencies are in the red against the U.S. dollar.
Given that major central banks are in full money-printing mode, the weakness is worrying, not least to the swathes of investors who have flocked in, lured by the promise of double-digit returns, robust growth and consumer demand.
Worrying maybe, but not surprising, says Martial Godet, head of emerging equity strategy at BNP Paribas.
Godet's calculations show a steep decline in return-on-equity (ROE) in emerging markets to around 12 percent, a fall of 3 percentage points in the last 18 months and well below pre-crisis levels of 16-17 percent.
That lags developed markets' 13.5 percent. But U.S. firms - "the ultimate quality and growth markets" in Godet's words - have usurped EMs' ROE supremacy with a 15 percent average. ROE shows how well a company is using shareholders' equity investment to generate profits.
"The deterioration has been both fast and large," he said.
"If you look at any of the criteria associated with profitability, you see that between 2011-2012 emerging markets were unable to transform economic growth into earnings growth."
Cash is still coming in - data from EPFR Global shows $33 billion in inflows to emerging equity funds in 2013, part of investors' so-called rotation out of bonds and into equities.
Most of this was soaked up by this year's new equity issues, totalling $30 billion according to Thomson Reuters data. But the ROE slump is a bad omen and inflows have started to stutter.
ING Investment Management for instance recently downgraded emerging markets holdings in its equity portfolio.
Robert Davis a senior fund manager at ING IM, notes flat corporate earnings in emerging markets last year despite revenue growth of around 12 percent.
Developed companies meanwhile have stayed profitable through years of economic doldrums, posting single-digit revenue growth in 2012 but managing a 2-3 percent rise in profits, he adds.
"Longer-term expectations of higher growth and demographics (in emerging markets) are valid, but what we have seen in the past couple of years is disappointment, because compared to developed markets, companies have been ... less able to protect their margins," Davis said.
Of course, within emerging markets there are countries and sectors that will continue to do well. And despite negative earnings, MSCI's emerging stock index rose 15 percent in 2012.
But profit margins are being eroded from both ends.
First, emerging markets are bearing the brunt of economic slowdown, argue UBS analysts, noting that the EM growth "spread" over rich peers has fallen to a 10-year low of 3 percentage points. As exports shrink, that hits corporate topline revenues, countries' current account balances and currencies.
And because global growth and emerging corporate profits have tended to move in lock-step, a 3 percent expansion rate for the world economy may be insufficient to generate a recovery in emerging earnings growth, UBS tell clients.
Separately, JPMorgan Asset Management, which has also gone neutral on emerging stocks, points out that past episodes of worsening external balances - 1997-1999, 2005 and 2008-2009 - have also coincided with emerging equity underperformance.
"We will be watching two sets of data - trade and earnings delivery - to gauge whether to put on renewed active positions," JPMorgan AM's multi-asset strategy team told clients.
Secondly, the crisis has hammered home emerging firms' inefficiencies, compared to their developed counterparts.
Input costs, including investment and wages, may even have been exacerbated as governments tightened control over economies in order to revive growth. That's especially so in the Big Four, BRIC countries, China, India, Russia and Brazil, where stocks are lagging S&P500 returns for the fourth year in a row.
"After the crisis, U.S. and other developed market companies really tried to improve efficiency by investing less, deleveraging balance sheets, accumulating cash and conducting optimisation of their operations," Godet said.
"EM companies continued to invest as if the crisis of 2008 hadn't happened, as if growth was just as strong as before."
Prices are yet to reflect all the fears, moreover. Expectations for 2013 earnings growth stand currently at 13.5 percent, compared to 8 percent for the United States and Europe.
JPMorgan AM says that its own composite valuation index based on forward price-to-earnings, price-to-book, price-to-cash flow and dividend yields, indicates a 17 percent valuation premium over developed companies.
Emerging markets will need to show superior earnings performance to justify this premium, it adds.
Deutsche Bank analysts are pessimistic about this prospect.
Those buying emerging stocks after 2008 joined the party too late, they say, predicting in a note that the sector is only 27 months into what may be a multi-year period of underperformance.
For Reuters polls on EM equities in 2013 see (Editing by Susan Fenton)
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