What caught my eye?v.89:What do EM market internals tell us?

In this issue, we ask what market internals are saying regarding health of EM &Asia ex equities. While macro dominates, market internals also play a part.

First, 12-mth forward EPS estimates for both the MSCI Asia ex and EM universecurrently appear slightly stretched, but apart from one or two markets are not asyet in danger territory. Unlike mid-‘16, when investors were expecting almost nogrowth, two years of consistent upgrades have given investors confidence toexpect another year of double-digit growth (~13%). Globally co-ordinatedrecovery reflated commodities and partially revived global trade. It was materials,energy and tech that led the charge in ’17, with tech being especially strong.

Over the last three months, Asia ex ’18 earnings expectations crept up further(estimates are up by 2% since Dec’17), driven by energy (up 10%), materialsand to a lesser extent financials. After massive upgrades in ‘17, tech earningsseem to have stabilized. On a country basis, the strongest momentum remainswith China/HK and Singapore (estimates up ~4%-5% since Dec’17). However,India is entering its fifth year of declining earnings momentum. Tech slow-down,weakness in consumer, utilities & autos are also yielding a weaker outlook forKorea. Despite global reflation, neither Mal nor Indo have strong momentum.

Given that technology now represents 26% of EM and 31% of Asia ex-indices(double its share five years ago), indices are highly sensitive to tech cycles andsomewhat less to generic business cycles. This particularly applies to NE Asia.

We remain believers in sustainability of tech secular drivers, and hence maintaina positive bias towards China, Korea and Taiwan. We also maintain that thelogic of the EM progression path (industrialization & factory migration) isbecoming redundant (here), and most EMs need to find new business models.

This threat has been offset by recent global acceleration; however, it is likely tore-asset itself. Hence, we maintain a negative bias towards non-NE Asia EMs.

Second, while fund flows are mostly voyeurism with limited relationship toperformance, at extremes they provide strong sell or buy signals, impactingrelative EM/DM performance. What do funds flows tell us? While there wereoutflows in Feb/Mar’18, since Feb’16, the EM universe benefited from a large~US$90bn net foreign inflow. Our preferred measure of annualized flow tomarket cap is now ~0.5%-0.6%, indicating that EMs are somewhat overbought;however to signal a major reversal, the ratio should be closer to 1%. In Asia ex,Indo is mildly oversold while Mal is overbought; the rest are broadly neutral.

Third, EM/Asia ex valuations are no longer cheap but neither are they expensive.

Relative to DMs, EMs at 12.4x forward PE, are trading at a 23% discount, or inline with historical averages while P/B (1.6x) represents a 29% discount to DMsvs LT average of ~20%. Value measures indicate that Thai, Indo and India are atthe high-end of the valuation range (compounded by aggressive estimates inIndia & Indo). There are no obvious overvaluations in China, Korea or Taiwan.

Following 25% out-performance against DMs since lows in early’16, EMs are atthe cross-roads. Unlike ’17, growth will be far less supported by the global cyclewhich is gradually running out of steam, and hence EM/DM EPS growth spreadis narrowing. Also neither valuations nor flows are as supportive. However, US$weakness (￥ strength) is reflationary while EM external vulnerabilities are lesspronounced. In our ’18 preview, we preferred EM, Europe & Japan to US. Whilerisks are mounting, at this stage, there are still no compelling reasons for suddenEM reversal. We believe in deepening divergence within EM and prefer secularstrength, scale and domestic liquidity. China remains our largest overweight.