The implications of collapsing profitability in EMs – Deutsche Bank
A micro approach to EMs equities still favor a global defensive value approach
We think that corporate profitability in emerging markets is collapsing and this will structurally reduce EM economic growth and dent the oil price. We think there will be too much supply in sectors with long asset lives, where investments have been made assuming a sustained growth in demand (e.g. Cement, Steel and Energy). This is also likely to have an impact on commodity exporting economies and markets (e.g. Russia). Low PE ratios for Energy and Materials are indicative of falling profitability rather than of real value, in our
view.
Lower profitability will lower economic growth in EMs
With real earnings for EM equities (ex Financials) back at 2007 levels, companies will need to rein back investment, and quickly, to safeguard longterm profitability. But this would in turn slow the economic growth in EMs.
Lower EM GDP growth is likely to create oversupply in Materials and Energy
A prolonged supply-demand imbalance in capital intensive sectors exposed to EMs is inevitable, in our view. The troubles in the Steel sector are evident; and Cement may be next; but the most important implications will be on the oil price. According to the US EIA, a structural fall of 10bps in the growth rate of non-OECD countries could bring the oil price down by up to $5 a barrel. A structural oil price down at $70 a barrel in the next five years is a real possibility in our view.
Seemingly attractive valuation ratios in Energy and Materials are not indicative of real value. Healthcare and IT remain the most attractive sectors.
The fundamentals of Energy and Materials look poor to us: too much capex at the wrong time, too much intervention from governments punishing shareholders and too much focus on (capital intensive) growth. This justifies the current sector de-rating, but a sharp adjustment in the commodity market is not in the share price.
Equities are fair value. Equity returns will continue to be in the low single digit range, with dividends accounting for an important part of total equity returns.
We maintain our year-end target of 1206 for the MSCI World (currently 1230), with a range of 943 to 1385.
The US remains our preferred market for the rest of 2012.
Investors may be tempted by the valuation of EM and European equities, but we argue that US remains the most attractive region on valuation. Value in EM or Europe is more optical than real. A lower oil price could be a positive for developed market GDP.
A bounce back from Aggressive Value is expected, but Defensive Value remains our favourite style for investors for the rest of the year.
Deutsche Bank
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