Forward momentum building in emerging-market equities

After five years of mostly negative returns and a rocky start to 2016, emerging-market equity indexes posted strong gains over the spring and summer, outpacing their developed-market counterparts—especially European indexes—by a wide margin.¹

Although it may be premature to declare that a sustained emerging-market (EM) equity comeback has arrived, most of the factors that we monitor are moving in the right direction, and appear likely to remain positive in the short term. As managers of an international equity strategy, our bottom-up securities analysis has recently identified a number of EM-domiciled stocks with the potential to provide a combination of high quality, strong growth, capital return to shareholders, and attractive valuations. As a result of these selections, our strategy recently increased its EM exposure to a modest overweight, and, from a macroeconomic perspective, we see improving EM economic activity reflected in the fundamentals of several of these stocks-improvement that we expect will afford plenty of additional EM equity opportunities for bottom-up stock picking within the asset class.

One of the catalysts that has driven the recent EM comeback is a turnaround in manufacturing across developing markets. In more than half of the world's EM economies, manufacturing purchasing managers' indexes were above 50.0—indicating expansion of manufacturing activity—as of July.² It was the first time in more than 12 months that a majority of these nations experienced manufacturing expansion rather than contraction.

This gain was achieved amid modest improvement in the global macroeconomic outlook, including prospects in developed-market economies that drive much of the demand for commodities and manufactured goods from EM countries. To gauge macroeconomic trends and recognize turning points, Wellington Management uses a measure called the Global Wave that combines seven independent variables relating to employment, inflation, business and consumer confidence, capacity utilization, credit conditions, and earnings revisions. Recently, these indicators bottomed out and, entering the summer, began to point toward possible improving growth, supported by stimulative monetary policy from central banks in China, Japan, and Europe.

Among the positive catalysts that we see for EM equities are attractive valuations, improving fundamentals, and strong structural tailwinds from the expansion of working-age populations in most developing countries, growth of the EM middle class, and urbanization.

Across the wide range of EM economies, our bottom-up analysis has recently identified several select opportunities in Brazil and China.

Brazil's economy has contracted for the past five quarters. This recession has been fueled by a decline in prices of crude oil and other commodities that Brazil exports, along with a political crisis that toppled President Dilma Rousseff, who was removed from office on August 31 following an impeachment trial-a sorry spectacle coming in the wake of the country's hosting of the summer Olympics in Rio de Janeiro.

While Brazil's equity market remains below its highs reached in 2008, the market has surged this year. Economic growth has recently showed signs of improvement, rebounding from the low base that is the legacy of Brazil's recession. The nation's central bank has embraced accommodative monetary policies and cut interest rates. We believe that this environment is supportive for Brazil's high-quality growth companies, some of which are trading at discounts to the market, in our view.

In China, we are troubled by a recent decline in employment and debt risks associated with the nation's banking system. However, we continue to see select equity opportunities within the domestic services economy, which the government has targeted for growth as China seeks to become less reliant on manufacturing exports. The equities of selected services companies in China's information technology and consumer discretionary sectors appear to us to offer attractive upside potential resulting from strong fundamentals and structural tailwinds as China's economy undergoes transition.

Regardless of current events in emerging markets, we will continue to seek opportunities in stocks—whether in the developing world or elsewhere—that offer a combination of high quality, strong growth, and capital returns to shareholders. In today's market, such stocks can be purchased at reasonable valuations, in our view, provided you know where-and how-to look. Increasingly, we are finding the emerging markets to be fertile ground for bottom-up stock picking.

1 Morningstar, Inc., 2016.

2 IHS Markit, 2016.

IHS Markit's Purchasing Manager Indexes are economic indicators derived from monthly surveys of private sector purchasing managers, who are asked about changes in business conditions. An index above 50 indicates an increase in business activity, while an index below 50 indicates a decrease in business activity.