As emerging markets (EMs) continue their ascent from the depths of a four-year bear market, headwinds continue to diminish.

In his latest investment note, Gary Greenberg, Head of Emerging Markets at Hermes Investment Management, discusses EMs’ strengthened prospects powered by the cyclical recovery and improving profitability.

Emerging markets rose from a four-year bear market last year to post an 8.5% gain, and have built on this in 2017 so far, posting 11.1% through to the end of March. The reasons for this recovery are primarily cyclical, and indeed performance has been led by the energy and materials sectors, which have returned 48% and 40% respectively since the beginning of 2016.

The headwinds that EMs faced during their bear market are abating, and the new ones may be weaker than many people believe. A strong dollar is one of them. US dollar bull markets have averaged between six and seven years in length since 1975; the current one turns six this month. Also, a stronger dollar is inconsistent with bringing back manufacturing jobs to the US, since, according to Trump, the stronger dollar is “killing us”.

‘Fragile five’ grow resilient

The fragile five – Brazil, Indonesia, India, Turkey, and South Africa – aren’t so fragile any more. There has been a sharp improvement in the aggregate external position of EM economies, making them more resilient to higher US rates. In 2013, the aggregate current account deficit of the fragile five was 4.5% of their GDP, making them highly dependent on foreign capital and particularly vulnerable to a rise in US yields.

The taper tantrum of that year hit these currencies hard. But now their combined deficit has fallen to 1.5%, and US rates could probably rise another 1% before the most vulnerable EM countries have to start tightening their belts further.

Commodities are last year’s trade

Commodity prices have also largely recovered, and renewed Chinese stimulus is unlikely, so betting on EMs as a commodity punt should be seen as last year’s trade. In any case, resource stocks account for only 18% of EMs, and resource-exporting countries only 42%. This means that the outlook for EMs is more likely to be decided by other sectors – consumer staples, discretionary, IT, industrials and financials – and by the other 58% of countries which import commodities.

Here the analysis is also positive, though more nascent. From 2011 through to 2015, EMs de-rated as their price-to-book valuations dropped from 2.1x to 1.2x following a precipitous decline in return on equity (RoE) during the period, from 16.6% to 10.3%. What happened? The majority of the decline in EM RoE was driven by a fall in margins, especially from the collapse in commodity prices, but this has started to improve and the RoE is now higher than that of developed markets (DMs).

Room for non-inflationary growth

And if the global reflation theme is sustained, there is room for non-inflationary growth in EMs, where unemployment is now high relative to history in many countries. In addition, the output gap of the region, according to estimates by the European Central Bank, has been in negative territory since 2015. The output gap in developed countries, in contrast, is in the process of closing. Therefore, wage and inflation pressures are beginning to diminish, providing relief for margins. Balance sheet management is also improving.

Declining capital intensity

After periods of euphoric over-investment in the late 1990s, early 2000s, and 2009-10, the capital expenditure-to-sales ratio has been in steady decline, though still somewhat higher than that of DMs. This drop signals a decline in capital intensity, and therefore better corporate free cash flow generation.

It should lead to better capital structures and stronger potential returns to shareholders, which can support a higher multiple for the market. The sector – adjusted P/E ratio of EMs has fallen back to its 10-year low compared with DMs, so a recovery looks probable. And we should remember that EM equity valuations are depressed relative to the US on a Shiller P/E ratio basis. With a competitive RoE and improving capital discipline, there is certainly potential for this gap to close.

Party not over yet

If bond yields are too low, capital won’t be attracted to EMs. EM equities tend to follow bond spreads, and real bond yields are high relative to their historical averages, meaning they should continue to attract capital. And we think EM equities are attractive relative to debt, the former having lagged the latter recently. After the constructive returns of the last 14 months, investors may be concerned that the party is over. We don’t think so. Flows have not yet turned significantly, and more than half of what entered EMs to drive its peak in 2013 has now left.

Cumulative flows into EMs are 58% lower compared to their peak. Apart from brief periods in 2014 and 2016, outflows have been dominant since the taper tantrum. So EMs still qualify as a contrarian play, although the first 15% move has already taken place. Spurred by a rebound in the commodity cycle, EMs are furthering their cyclical recovery with the prospect of better profitability, solid free cash flow generation and improved returns to shareholders.