Emerging market stocks navigate crosscurrents

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Q1 2022 Putnam Emerging Markets Equity Fund Q&A

• Emerging market stocks underperformed amid the fallout from the war and declining risk appetite.
• We continue to see attractive valuations and faster earnings growth for EM companies.
• Our outlook remains positive for emerging markets despite headwinds — such as war and rising global interest rates — this year.

How was the investment environment for the first quarter?

It was a challenging quarter for emerging markets [EM] amid increasing headwinds. Hawkish policy pivots from the U.S. Federal Reserve and other G10 central banks in the face of rapidly rising inflation, combined with Russia's invasion of Ukraine, fueled a flight from risk. The S&P 500 Index, a broad measure of U.S. stocks, returned –4.60%. The MSCI World Index [ND], a broad measure of equity securities from developed countries, returned –5.15% during the period.

In mid-March, the Fed lifted the federal funds rate to a range of between 0.25% and 0.50%. Fed Chair Jerome Powell signaled an aggressive approach going forward, indicating that additional hikes could occur at each of the remaining six policy meetings in 2022. Central banks in some developing countries, including Brazil, Chile, and South Africa, have raised interest rates. In addition, China has introduced lockdowns in Shanghai and in other cities amid surging Covid-19 infections. We believe there will be economic fallout from these disruptions.

Despite uncertainties during the year, our outlook remains positive for emerging markets. For the first quarter, Putnam Emerging Markets Equity Fund returned –11.87% compared with a return of –6.97% for its benchmark, the MSCI Emerging Markets Index [ND].

What is attractive about emerging market stocks at this time?

We continue to see attractive valuations, faster earnings growth, and economic expansion for a large swath of developing countries. We remain optimistic on the outlook for EM equities relative to the United States for several reasons. Stocks of companies in developing countries, including technology companies, are much cheaper, on average, than those of U.S. companies, in our view.

Valuations for EM equities are compelling at 12 times earnings, versus 21 times for U.S. stocks. As an example, Brazil's Petrobras [Petróleo Brasileiro S.A.] has a free cash flow yield of 37% because of strong oil prices. We expect EM earnings growth to outpace the rate for U.S. stocks listed in the S&P 500 Index in 2022. Going forward, we believe earnings-per-share growth for companies in developing markets will be driven by innovation and faster economic growth. Stock prices will follow earnings in the long run, in our opinion.

In addition, the U.S. accounted for about 16% of global gross domestic product, and that share is expected to decrease. That means the U.S. economic contribution globally has been falling amid the rise of manufacturing and technology innovations in countries such as China and India. And finally, the monetary policy cycle in developing countries is diverging from the Fed. As the Fed raises interest rates, many EM countries are likely to go on an easing path. These central banks had raised rates last year.

We also expect to see improved sector and country compositions in the MSCI Emerging Markets Index. Ten years ago, energy, materials, and traditional telecoms made up 50% of the index. These sectors now compose about 20% of the index, while technology, health care, and consumer stocks make up the majority. Today, the EM universe of stocks is not about the large, secular, underperforming state-owned enterprises like Chinese banks but leaders in semiconductors, fintech, and gaming.

What is your near-term outlook for emerging market equities?

We remain attuned to macroeconomic concerns, such as rising inflation, higher interest rates, and supply chain disruptions. We are also monitoring geopolitical issues related to the Russia-Ukraine War and their potential impact on global financial markets. We are aware, as seasoned investors, that continued emerging market volatility is likely in the months ahead. However, we also see many opportunities to find companies that are navigating these headwinds.

Many emerging market countries are in stronger financial condition today than in recent years. While the outlook for emerging markets seems to have deteriorated slightly, it is not uniform across the board. The surge in commodity prices will likely help some emerging market exporters to meet their external financing needs and add to their fiscal cushion. We continue to believe that rapid innovation in Asia will transform the equity landscape in the 2020s and 2030s.