(June 22, 2012) — Emerging market investors should focus on macroeconomic factors in the long-run, a whitepaper by Credit Suisse concludes.
Macroeconomic data should be augmented with other variables, such as monetary policy indicators, price momentum, and earnings momentum, to take account of more immediate market dynamics, according to the paper. “In particular…inflation and the exchange rate play a critical role in determining equity returns,” the paper said.
The authors indicate that while growth is important, it’s not the whole story. “For most investors, the attraction of investing in emerging economies is the growth story based on the expectation that they will grow faster than developed economies, and that this will result in their equity markets outperforming developed world indices,” the authors write. Yet while “growth” usually means real GDP growth, historical evidence shows that the correlation between equity returns in US dollars and real GDP growth is actually quite weak.
While macroeconomic variables matter when it comes to indicating the rate and quality of country growth, their relationship with equity market performance can only be established over the long run. “Our approach, therefore, is to supplement the core macro model with higher frequency variables,” the authors conclude.
Another critical perspective on evaluating emerging markets came from a research team at a major European bank earlier this year when it told investors that they should avoid emerging markets and not expect too much from equities due to their poor earnings potential and downside risk. Deutsche Bank looked at investments on a “cash return on capital invested” (CROCI) basis and said 2012 would be another tough year for equity investors. The paper’s authors wrote: “Our core scenario is for a total return of around 5%, with dividends accounting for the bulk of this return, although the possibility of a second year of negative returns in a row cannot be ruled out.”
The paper concluded that while equities looked cheap at the moment, they were only cheap on long-term assumptions and there was very little real earnings growth in equities around the world. The bank’s analysts also said earnings downgrades would loom over the year, pulling down world indexes and company valuations. There have already been significant warnings to the market. In January, technology giant Motorola announced an earnings warning in the US, which was followed by Australian bank Macquarie this week warning investors that its profits had been hit by the tumultuous market conditions.
Emerging markets, seen among many as the growth engine for the world economy, offer no solace for investors, according to Deutsche Bank’s paper. It said that despite annual GDP increases for many of these nations sitting comfortably in double digits, emerging market equities showed a lack of real earnings growth. “Real earnings for emerging market Industrials have remained unchanged since 2007. Growth in inflation adjusted earnings per share for Brazil, Russia and India has not beaten the US since 2007. China appears to be leading the pack with phenomenal EPS growth, but we fear that this EPS growth is more illusory than real, as Chinese banks may be significantly underestimating their loan provisions.”