Why Emerging Market ETFs Are Surging

May 16, 2017

Geoffrey Dennis is head of global emerging markets strategy for UBS Investment Bank, a role he has held for more than three years. Prior to that, he was global emerging markets strategist for Citigroup for 14 years.

ETF.com: Why have emerging market equities risen so sharply this year after several years of underperformance?

Geoffrey Dennis: Emerging markets began to rally in late January last year. That's when the bottom was. We started the year very badly last year, so we were already in a 13% hole by the third week of January. We also had a pullback after the U.S. election, which was a surprise, and led people to pull money out of EM equities and put money into U.S. equities.

We had a lot of volatility last year, which meant the full year only had a gain of 8.5%. But the really important story is how much we came off of the bottom. We had a pretty good rally for essentially 11 months of last year, and now we've gone a bit further.

You have to break it up between what initially was the driver of the rally and what's become the driver lately. Initially, the driver was the rebound in commodity prices, the fall in the dollar, and the improvement in sentiment towards the global economy.

On the other hand, what's driving EM higher this year is the earnings story. We have this wonderful database that we call GEM Inc., and that database is giving us 26% earnings-per-share growth for 2017 in dollar terms. That would be the highest earnings growth number since 2010.

Last year, earnings growth in emerging markets was about 8 to 10%, which is very similar to the return for EM equities. Prior to that, between 2011 to 2015, you had a five-year period where earnings growth was very negative. That had a lot to do with collapsing commodity prices and a rising dollar. The dollar plays a tremendous role in EM; I've always argued that.

After five years of terrible performance, we're finally starting to see an improvement in profitability measures for the emerging markets.
ETF.com: There's been a lot of talk about how emerging market equities are cheap in terms of valuation. Do you agree?

Dennis: What's happened is that EM is up 15% this year, and the valuations have not moved, and that's because the earnings upgrades have been very significant.

However, EM today is trading between 12x and 12.5x forward earnings, compared to the long-term average of 11. It's not cheap historically, although it's cheap against the developed world.The high for this particular cycle—if you go all the way back to 2010/2011—is around 13x forward earnings. EM equities are expensive, but they're not as expensive as you might think by looking at how much markets have gone up this year, and that's because the earnings story has been strong.

The most interesting and more compelling story vis-a-vis valuations is versus the developed markets. We're sitting at about a 25% discount on a forward P/E basis to developed markets, and that's smack in line with the long-term average.
 

Find your next ETF

Reset All