EM Strategy Views:Reflation resurgence and the EM “melt-up”trade

With reflation back in focus is EM in danger of “melting- up”? Despite thecurve flattening in the US, rates are rising and breakeven inflation is followingsuit. Along with reflation comes the fear of assets in bull markets “melting-up”,which refers to valuations overshooting as the cycle matures, leading to a spike inprices before a reversal. However, we do not find that this risk is relevant to thecurrent EM run, as it has been driven largely by improving earnings and abroad-based acceleration in economic growth.

EM equities owe strong performance to rising earnings, valuations haveroom to improve vs DM. Of the 34% rise in MSCI EM in 2017 22% isattributable to local currency EPS growth, 5% to EMFX appreciation, and just 5%to increases in valuations. The historical relationship between relative valuationsof DM cyclicals vs defensives and EM vs DM has broken down recently with a“growth premium” forming in DM assets while EM lags. This suggests that EMvaluations have significant room to improve based on improving economicfundamentals and a rosier earnings outlook.

Credit spreads are moving in line with stronger growth and have room totighten further. EM spreads are tight, but aggregate EM spreads tend to pricerelative to growth and from that framework they look fairly valued. EM vs US HYspreads typically move in line with DM cyclicals vs defensives valuations, but thatrelationship has also broken down leaving early cycle EM credit poised to gainground on what we believe to be an ageing US corporate credit cycle.