Falling earnings provide reality check on AI-led rally in emerging market stocks
Earnings season is nearly over, with 96% of companies in the MSCI Emerging Markets Index completing their quarterly results. And the situation is not very good. Nearly half of the companies missed analyst estimates, average revenue was down 10% compared to the previous year, and companies brought in only 86 cents for every dollar of projected revenue. An 18% increase in profits two years ago helped emerging companies beat expectations.
That means emerging market stocks may struggle to sustain a $2.1 trillion rally driven by trends such as a rush into AI-related stocks and optimism about a quick economic recovery following China’s stimulus package. Those bets are shrinking as China, the world’s second-largest economy, struggles with weak consumer demand and a price war among AI companies spooks money managers.
bloomberg“The downside surprise in earnings expectations was mainly driven by weak earnings momentum in China,” said Nenad Dinic, equity strategist at Bank Julius Baer in Zurich. Elsewhere, it pointed to wage increases in Brazil, Colombia, Mexico and India, saying “the decline in margins appears to have been driven by higher operating costs.”
The latest earnings season saw eight missing quarters for the average emerging market company, according to a comparison of trailing 12-month earnings per share from the MSCI index with earnings estimates compiled by Bloomberg. The company’s results have lagged so far behind investor expectations that profits would need to increase by as much as 24% next year to catch up with current forecasts.
“This is certainly a risk for emerging market equity gains, and if the performance disappointment continues, there will be an impact at some point,” said Marcus Weyerer, chief investment strategist at Franklin Templeton Investment Management Ltd. . Weyerer said if companies continue to miss expectations, their stock prices could fall 10 to 15 percent.
The MSCI EM index rose 15% from January 17 to May 20, but fell 4.8% through May 31 due to weakening sentiment toward AI stocks. Technology stocks in China and AI hubs Taiwan and Korea are leading the decline.
The performance of mainland Chinese companies last quarter was the weakest since April 2018, shortly after the trade war between the United States and China began. Chinese companies listed in Hong Kong announced performance showing a slight recovery after hitting the lowest level in at least 10 years.
a stingy consumer
Weak consumer spending is one of the reasons for poor corporate performance, not only in China but across emerging markets.
For example, Unilever Plc’s India unit reported first-quarter net profit that was 5.5% lower than analyst estimates. The reason behind this decline was a combination of sluggish rural demand and high net worth urban consumers turning to other brands. Similar trends can be seen elsewhere, with Chilean retailer Cencosud SA, restaurant chain operator Yum China Holdings Inc. and Swiss-South African jeweler Compagnie Financiere Richemont SA all posting weaker-than-expected results.
Chinese consumers are “looking to preserve wealth,” said James Johnstone, co-head of emerging and frontier markets at Redwheel in London. “The very exciting post-pandemic revenge spending is over and people are tightening their belts.”
Unlike China, where deflation is helping companies control costs, other emerging markets are struggling after three years of high inflation. However, competitive pressures and price-sensitive consumers are still reeling from the economic impact of Covid-19, meaning businesses are unable to pass on these costs.
Meanwhile, the AI price war is putting pressure on corporate performance. Alibaba Group Holding Ltd. has cut prices on some of its services, prompting rivals to do the same. Investors are reluctant to take advantage of the range of discounts offered (up to 97% for some services) and are reconsidering further investments in the sector. Chinese tech stocks fell 11% in just nine trading days.
bloombergOperating profit margins in emerging countries have fallen by more than 3 percentage points on average over the past two years. Industrial companies, financial institutions, technology companies and real estate developers fared worst, according to Julius Baer’s Asia study.
central bank dilemma
There is another factor hindering corporate profits. The pace of monetary easing is slowing down. Some developing countries began cutting interest rates as early as mid-2023, but progress has been slowed by delays in the Federal Reserve’s policy shift and the dollar’s resilience putting pressure on local currencies.
Currently, policymakers are focused on supporting their currencies. “Despite the scope for rate cuts, several emerging market central banks remain hawkish,” Dinic said. “Poor corporate performance appears to be secondary to broader macroeconomic stability.”
