Challenging Consensus: Is EM the Road-Map for Europe?
* From value trap to value trade — EM equities have been a 5-year bear trade, driven by slowing growth and high levels of macro risk (China, commodities, US$, deficits). Valuation did not provide support; a classic "value trap". But, EM equities have enjoyed a resurgence YTD. Markus Rosgen, Citi's EM Equity Strategist, remains positive and we raised EM to Overweight in our global regional allocation in February. EM equities have moved from "value trap" to "value trade" as risks have fallen and growth prospects have improved.
* Falling risks — There have been four key EM risks over the last five years: 1) China, 2) commodities, 3) US$, and 4) deficits. We see signs of greater stability in both commodity and US$ markets. Current account deficits have also reversed across EM; in aggregate, from big deficit to small surplus over the last 2-3 years. China remains a risk with slowing growth and rising private sector debt, but authorities have shown that they still have tools to manage risks. Overall, the risk environment across EM has improved.
* Improving growth — We also see an improving growth backdrop for EM after five years of GDP and EPS downgrades and disappointments. Citi economists expect 2017 to be the first year of "positive GDP growth delta" in over five years driven by Russia and Brazil. We agree. EM is the first region to see EPS stabilise in the last 3 years above 0%, instead of falling from c10% to 0%. EM EPS growth expectations for 2016E have stablised around 6-7%.
* Returns, re-rating, leadership — A falling risk and improving growth mix has been positive for EM equities this year, which have returned c11% YTD and have also been re-rated. Better performance has been accompanied by new leadership, ie Brazil, Russia, risk, value, commodities, Financials. Previous winners have become laggards and sources of funds for this new leadership group.
* Does Europe follow EM's lead? — We think that EM's experience will echo across Europe over the next 12-18 months with reducing risk and improving growth. Reducing risk could come from: 1) unrealised political risk, eg Renzi still in power, no Le Pen government, 2) improving external environment, eg move from "mixed" to "synchronised" global GDP growth (in US$ terms), 3) further strengthening, restructuring, consolidation in European banks. Unless PMIs in Europe and the US fall to the mid-40s or unless there is a big EPS recession in a single (and big) European sector, we think it is likely that EPS growth in 17E is able to reach 5-10%.
* Challenging the consensus — This outlook presents a challenge to many investors in Europe and around the world. A combination of central bank actions and high levels of macro, including political, risk has reduced most financial market participants to "data dependent" status. We see our base case as plausible, reasonable and likely. The implications for European Equities (upside risk) and leadership reversal is not how many investors are positioned. We stick to five conclusions:
1) Overweight EM, 2) Overweight commodities, 3) don't Underweight Banks, 4) Overweight de-equitisation, 5) hedge political risk.