By Sujata Rao
LONDON (Reuters) - Emerging market equities have a spring in their step as an upswing in company profits extends a year-long 40 percent rally in the sector and allows investors to look past the threat of a global trade war.
MSCI's emerging equity index - the benchmark for funds managing almost $2 trillion - posted positive returns in 2016 after three years in the red and are up 10 percent already this year.
Signs are more investors are joining in.
Global funds swung this month to a 5 percent overweight on emerging stocks, reversing 6 percent underweight in January, according to Bank of America (NYSE:BAC) Merrill Lynch's closely watched survey of investors managing $632 billion.
Last year's rise was mostly driven by commodity prices recovering and the U.S. Federal Reserve holding off on rate rises. Now, many expect that Donald Trump's U.S. election win will benefit emerging markets if the impact of mooted extra spending and tax cuts trickle through to them.
What's more, his threats for a "big border tax" and criticism of other countries' currency policies have weakened rather than strengthened the dollar.
More importantly, the picture within emerging markets has brightened - economic growth accelerated to a four-year high at the end of 2016, according to an index compiled by the Institute of International Finance, the Washington-based finance industry body.
That, along with the stabilization in oil and metals revenues, is feeding through to emerging markets' return-on-equity (ROE) - a gauge of how efficiently a company uses shareholders' money to generate profits - rebounded last year after hitting multi-year lows: http://reut.rs/2loFJWZ
Earnings-per-share for MSCI's emerging equity index are forecast at 15.2 percent in the coming year, according to Thomson Reuters I/B/E/S. The estimates have also steadily been raised and upward revisions are at the highest level since 2010:
"You have on one hand the Trump worries but if you look at (emerging market) fundamentals such as earnings and economic growth these have really improved," Supriya Menon, senior multi-asset strategist at Pictet Asset Management, said.
"We've seen quite a strong pick-up in earnings ... now there is a 3-4 percentage point differential in expected earnings-per-share growth (between emerging and developed markets) and we think there is room for further upgrades," Menon added.
Credit Suisse (SIX:CSGN) analysts highlight three reasons why emerging equities could gain further. First, robust prices for commodities which typically provide over a 10th of emerging companies' earnings; recovering industrial output and finally, improvements in productivity.
The bank said productivity - or output per hour - was now growing faster than wages for the first time in a decade in China, Brazil and Russia, and the first time in five years for the developing world as a whole.
In other words, unit labor costs are declining, it added.
"There was a multi-year decline in ROE and part of that was down to wage inflation being persistently higher than productivity growth," said Julian Mayo, co-CIO at emerging markets-focused Charlemagne Capital.
Mayo also noted a sharp slowdown in capital expenditure, which tends to be higher than in developed countries - Credit Suisse estimates the ratio of capex to sales this year will be the slowest this century in emerging markets at 8 percent.
RISKS
The rally is not without risk, however, because of rising U.S. interest rates and fears of U.S. protectionism, stemming from Trump's threats for "a big border tax" and criticism of the currency policies of China, Germany and Japan.
There are fears Trump's Mexico threats are merely a prelude to an assault on his real target - Asia, especially China which has a $350 billion trade surplus with Washington.
Many funds bullish on emerging equities say they still await clarity, focusing for now on Trumpflation's positives.
"The idea of a more aggressive (U.S.) trade policy, that would point torward an underweight on manufacturers versus commodity producers, is not driving portfolio positioning this far, but it's an area that may become relevant," BlackRock portfolio manager Gerardo Rodriguez said.
The United States provides 20 percent of revenues for more than a fifth of companies on the MSCI Asia index, Morgan Stanley (NYSE:MS) estimates.
Emerging equities tend to be more closely correlated to economic growth rates than their developed peers, a further sharp slowdown in trade from today's already anemic rates would be a game changer for the sector.
Pictet's Menon recognizes "significant" tailrisks, hedging her position by buying long-dated U.S. bonds to guard against the risk of deflation and keeping a relatively small overweight on emerging equities.
"We are quite cautiously positioned relative to what the (emerging markets) data would indicate," she added.
(Graphics by Vikram Subhedar and Marc Jones; Editing by Alison Williams) OLUSMONEY Reuters US Online Report Money 20170223T164521+0000