Sinking profits bring reality check to AI-driven rally in emerging market stocks

That suggests EM stocks could struggle to sustain a $2.1 trillion rally that’s been driven by trends such as the rush into AI-related stocks and optimism about a quick, stimulus-driven in China. Those wagers are waning as the world’s second-largest economy suffers from and a among companies spooks money managers.

Bloomberg

“The downside surprise in profit expectations is largely driven by weak earnings momentum in China,” said Nenad Dinic, an equity strategist at in Zurich. Elsewhere, “the erosion in margins appears to come from rising operating expenses,” he said, pointing to wage increases in Brazil, Colombia, Mexico and India.

The latest earnings season marks eight quarters of misses for the average emerging-market company, based on a comparison of trailing 12-month earnings per share for the MSCI index and earnings estimates compiled by Bloomberg. Companies’ results are trailing investor expectations so much that profits have to jump 24% over the next year just to catch up with current forecasts.

“That’s definitely a risk for the EM stock rally,” said Marcus Weyerer, a senior investment strategist at . “If we see disappointments in earnings continue, then at some point it’ll have an effect,” he said. Stocks could decline by 10% to 15% if companies continue to miss estimates, Weyerer said.

The MSCI EM index advanced 15% since Jan. 17 through May 20, before weaker sentiment toward triggered a 4.8% fall through May 31. from China and the AI hubs Taiwan and South Korea are leading the declines.

Chinese mainland companies in the past quarter reported the weakest earnings since April 2018, soon after the trade war between the US and China began. Hong Kong-listed Chinese companies posted results that showed a marginal recovery after hitting the lowest level in at least a decade.

Stingy Consumers
Sluggish consumer spending is one cause for poor corporate performance not just in China, but across emerging markets.

For instance, ’s Indian unit reported a 5.5% drop in net income for the first quarter, missing analyst estimates. Behind the decline was sluggish rural demand combined with high net-worth urban consumers pivoting to other brands. Similar trends can be seen elsewhere, with Chilean retailer , restaurant chain operator Yum China Holdings Inc. and Swiss-South African jeweler Compagnie Financiere Richemont SA all delivering weaker-than-expected results.

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.”

Unlike China, where deflation helps companies control their costs, other EM countries are struggling after three years of elevated inflation. But competitive pressures and price-sensitive consumers still reeling from the economic impact of Covid mean companies are unable to pass these costs on.

Meanwhile, a price war in AI is putting corporate performance under pressure. Alibaba Group Holding Ltd. dropped prices of some of its services, spurring its rivals to do the same. Investors are balking at the extent of discounts that are being offered — as much as 97% for some services — and reconsidering further investments in that area. A gauge of Chinese tech stocks has slumped 11% in just nine trading days.

Bloomberg

On average, the operating-profit margin at EM companies has fallen more than 3 percentage points in the past two years. The deterioration was worst for industrial companies, financial institutions, technology firms and real estate developers, Julius Baer’s research in Asia shows.

Central-Bank Dilemma
There’s one more thing hampering corporate profits: A deceleration in the pace of monetary easing. While some developing countries started cutting interest rates in mid-2023, progress has slowed as delays to the Federal Reserve’s policy pivot and the dollar’s resilience are putting pressure on local currencies.

Policymakers, for now, are focusing on supporting their currencies. “Despite room for rate cuts, several EM central banks remain hawkish,” said Dinic. “Poor corporate performance appears to be a secondary concern compared to broader macroeconomic stability.”