JOHANNESBURG – The MSCI Emerging Markets Index has fallen more than 10% in 2018, and more than 20% from its peak in January. US monetary policy normalisation and a rising growth differential have driven a strong US dollar, negatively impacting emerging markets (EM) currencies and financial conditions.
Although the US has delayed implementation of tariff increases on $200 billion of Chinese goods, we expect the trade conflict between the two countries to resume. In addition, a negative credit impulse in China and rising uncertainty on the trade outlook has affected Chinese growth and global trade. Sentiment is now cautious and valuations have de-rated.
To what extent is this a buying opportunity, or should we remain cautious about the future?
Aggregate valuations are attractive, with both price-book and price-earnings ratios below their long term averages, as highlighted in the chart below. Sentiment is cautious, but investor allocations remain elevated following significant inflows into EM funds in 2017.
Valuation multiples price in a cautious earnings outlook. Earnings per share revisions have been negative and may remain so, which may act as a headwind to a multiple recovery.
The announcement of a delay in US tariff rises on $200 billion of Chinese goods, previously scheduled for 1 January, is welcome. However, the dispute is as much concerned with issues such as technology transfer as it is simple trade volumes. The US is likely to demand concessions which China may regard as designed to contain its economic aspirations and global influence. Consequently, we expect a resumption in trade tensions in 2019.
In addition to potential tariff increases, it is also possible that further tariffs are introduced on the remaining $270bn of Chinese exports to the US, though this may have a more visible inflationary impact on US consumers. The trade conflict potentially creates supply chain disruption for a wide range of industries and is likely to impact corporate confidence and investment as well as trade. Renewed escalation would further suppress sentiment and create uncertainty.
Despite an initial positive reaction from markets, sentiment remains cautious regarding further escalation and there is a degree of risk asymmetry. We do not believe an easy resolution will be found, but should the current truce hold and further escalation stall, this would likely be positive for markets, especially if this comes in conjunction with ongoing Chinese stimulus and US dollar weakness.
In China, regulatory tightening has driven a negative credit impulse, while the government has also focused on prioritising the quality of growth. This has caused economic momentum to slow. In the second half of 2018 we have seen the re-initiation of monetary, fiscal and infrastructure stimulus, in addition to a degree of regulatory forbearance.
We think that stimulus will remain relatively constrained in comparison with prior episodes: regulatory tightening in the financial sector is designed to improve risk in the financial system and will likely remain a priority; a large stimulus may also affect the current account, which moved negative in the first half of 2018, and pressure the currency.
The US dollar is strongly inversely correlated with EM equity market performance. The dollar is the external funding currency of choice for EM and impacts EM financial conditions. We expect the dollar to depreciate modestly in 2019. The currency is expensive and we anticipate US economic momentum will slow, given fiscal fade and the lagged impact of monetary tightening. If the dollar declines and we have passed peak yields for the US 10-year Treasury then EM currencies, economies and markets are likely to see relief. This is an important catalyst.
Identifying the opportunities within EM
Disaggregating EM equities, we see opportunities in terms of growth, valuation and earnings. We favour Korea, which is exposed to global growth, but where valuations in certain cases now price in a negative earnings outcome. Russia offers compelling value including on cash flow, yield and currency. In Brazil, political risk remains, but the new president’s anticipated economic policy framework could support a recovery in growth. The outlook in Poland and Hungary is also favourable, given the positive earnings outlook and attractive valuations.
Valuations supportive but risks bear monitoring
Overall EM valuations are supportive and we continue to monitor the extent to which the risk of further trade escalation is already priced in; the potential for US dollar weakness in 2019; and whether Chinese stimulus will ease growth concerns. These factors might act as a catalyst for EM market performance in 2019. However, the strength of a potential recovery is tempered by a more cautious global growth outlook, as the US is late in its economic cycle and well advanced in its monetary tightening cycle, and we expect Chinese growth to be slower on a medium-term basis.
Tom Wilson is head of emerging market equities at Schroders.
The views expressed here do not necessarily reflect those on Independent Media.