As the excitement around artificial intelligence and China’s economic stimulus wanes, a familiar challenge reemerges for equity investors in emerging markets: declining corporate profits.
With 96% of companies in the MSCI Emerging Markets Index having reported their quarterly results, the earnings season paints a grim picture. Nearly half of these companies missed analyst estimates, with average profits plunging 10% compared to the previous year. For every dollar of predicted earnings, companies are only realizing 86 cents, a stark contrast to two years ago when profits surged 18%.
This trend indicates that emerging market stocks may struggle to sustain the $2.1 trillion rally driven by AI-related stocks and optimism about a rapid economic recovery in China. However, these expectations are fading as China’s weak consumer demand and a price war among AI companies dampen investor confidence.
The downside surprise in profit expectations is largely driven by weak earnings momentum in China.
“The downside surprise in profit expectations is largely driven by weak earnings momentum in China,” said Nenad Dinic, an equity strategist at Bank Julius Baer in Zurich. Elsewhere, “the erosion in margins appears to come from rising operating expenses,” he added, citing wage increases in Brazil, Colombia, Mexico, and India.
For the past eight quarters, the average emerging-market company has consistently missed earnings expectations. Profits would need to jump 24% over the next year just to align with current forecasts. “That’s definitely a risk for the EM stock rally,” said Marcus Weyerer, a senior investment strategist at Franklin Templeton Investment Management Ltd. “If earnings disappointments continue, stocks could decline by 10% to 15%,” he warned.
The MSCI EM index rose 15% from January 17 to May 20, before a 4.8% decline due to weaker sentiment towards AI stocks. Technology stocks from China and AI hubs Taiwan and South Korea have led these declines.
Chinese companies reported their weakest earnings since April 2018 in the past quarter. Hong Kong-listed Chinese companies showed only a marginal recovery after hitting the lowest earnings levels in at least a decade. Sluggish consumer spending, not just in China but across emerging markets, is a significant factor in poor corporate performance.
Unilever Plc’s Indian unit reported a 5.5% drop in net income for the first quarter, missing analyst estimates. Sluggish rural demand and high net-worth urban consumers shifting to other brands contributed to the decline. Similar trends are observed in other companies like Chilean retailer Cencosud SA and restaurant chain operator Yum China Holdings Inc.
Chinese consumers are “looking to conserve 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,” he added.
Unlike China, where deflation helps control costs, other emerging market countries are grappling with elevated inflation. However, companies face competitive pressures and price-sensitive consumers, preventing them from passing on increased costs.
If earnings disappointments continue, stocks could decline by 10% to 15%.
A price war in AI is also putting corporate performance under pressure. Alibaba Group Holding Ltd. slashed prices of some services, prompting rivals to follow suit. This has led to a significant decline in Chinese tech stocks, which have slumped 11% in just nine trading days.
Operating-profit margins at emerging market companies have fallen by over 3 percentage points in the past two years, with industrial companies, financial institutions, technology firms, and real estate developers experiencing the worst declines.
Central banks in emerging markets face a dilemma. While some countries started cutting interest rates in mid-2023, progress has slowed due to the Federal Reserve’s policy stance and the dollar’s resilience, putting pressure on local currencies. Policymakers are focusing on supporting their currencies, with corporate performance being a secondary concern.
