Emerging markets (EM) have come under pressure in the second quarter due to idiosyncratic problems in a few countries as well as global trade tensions, a strengthening US dollar and higher US Treasury yields. Many of the tailwinds that caused EMs to outperform in 2017 such as accommodative monetary policy, a weakening US dollar and the growth differential over developed markets (DM) have subsided or started to reverse. As a result, as of early June, we saw the highest outflows from both EM equity and debt in 18 months.1
However, across the EM universe, economic fundamentals remain broadly supportive, inflation relatively under control and currencies undervalued in aggregate. The growth differential between EMs and DMs is expected to widen over the next few years, higher commodity prices should bolster EMs in aggregate and EM yields remain attractive. In such a climate, we have brought our EM equity exposure down a gear, but remain cautiously overweight and ready to capitalize on opportunities created by short-term volatility. We remain constructive on EM debt, though with a preference for local currency bonds and increasingly selective as the credit cycle ages.
Global Trade Volumes: Potential Tariffs Weigh Heavily
At the start of 2018, world production growth appeared robust, but in March, it dropped sharply (see Figure 1). This may be partly due to the year-on-year comparison with a peak in 2017, as well as the timing of the Chinese New Year when activity typically dwindles. However, it is likely that some of this falling off is due to unease over global trade tensions caused by the US’s threatened imposition of tariffs and the inevitable retaliation from other countries.
While global GDP growth on the whole remains strong and global trade volume growth may reaccelerate following the recent downshift, this bears watching closely. Export orders in EMs have softened just as the domestic policy backdrop is becoming less supportive (i.e., rate hikes). Protectionist rhetoric already appears to be having a disproportionate impact on EMs, even before material restrictions have been applied. Mexican bonds and the peso, for example, have suffered amid tough NAFTA renegotiations.
US Dollar: Strength Ahead Helps EM Local Currency Debt
Political uncertainty in Europe (especially in Italy) and lower-than-expected Eurozone growth have contributed to euro weakness against the dollar. Capital flows to Europe, which last year offset tighter US monetary policy and kept the dollar range-bound, have paused. As a result, we believe we could see continued dollar strength this year. However, according to our measures of fair value, EM currencies are in aggregate 5-6% undervalued against the dollar, this compares favorably to the start of the Taper Tantrum in 2013. It is this relative value opportunity that underpins our constructive view on EM local currency debt (see Figure 2 and Figure 3).
Debt: A Focus on Local Currency Credit Quality
Many EMs now issue debt in their local currency as opposed to hard currency (e.g., the US dollar), much of which is held by domestic investors, making it less subject to the vagaries of international flows and less sensitive to dollar moves. EM balance sheets are typically better managed than in the past and many have been able to reduce interest rates thanks to successful inflation-targeting by central banks. While monetary policy in aggregate is beginning to change direction, more EMs have been issuing longer term debt, meaning that they should be able to service it for some time yet, despite the dramatic increase overall in EM debt issuance since the global financial crisis.
While external shocks may pressure the more vulnerable EMs, we believe healthier aggregated EM current account balances should reduce the likelihood of contagion risk from embattled countries such as Turkey, Argentina and Brazil. Against a backdrop of higher US interest rates and a stronger dollar, Brazil’s difficulties might ultimately infect other EMs, but we are not there yet. While EM inflation between 3.5% and 4% remains higher than in developed markets, it is far lower than in previous decades for both EMs and DMs.2
Despite short-term macro risks such as dollar strength and the potential for further trade turmoil, we prefer local currency over hard currency EM debt. Local currency credit quality is often higher and typically offers better spreads over hard currency debt while being less sensitive to US interest rate risk. Local currency debt should benefit from any medium-term correction in the undervaluation of the currencies against the US dollar.
Earnings Growth: EM/DM Differential Narrows
EM equities outperformed DMs last year, but the earnings growth differential has since narrowed. According to consensus forecasts, EM earnings should grow 15.9% in 2018 versus 15% in DMs. Last year, the differential was 500-600 basis points. This narrowing is principally due to the immediate impact of the US tax cuts, so we expect the differential to start widening again in 2019 as this effect plays out. Last year, earnings accounted for the largest proportion of EM returns since 2010 (Figure 4). This year, earnings and dividends are still positive but weighed down by negative currency and price-to-earnings (P/E) effects. However, earnings expectations for the rest of 2018, while below last year, are still ahead of the five years before 2017.
Implications: “Guilt by Association” Creates Opportunities Upon Closer Examination
Given the earnings story is less compelling than in 2017, it is no surprise that the noise around higher rates, currency moves and idiosyncratic country risk have undermined confidence in EM equity markets. However, the reversal in flows to EM equity markets is unearthing new attractive entry points for long-term investors, especially if the US 10-year rate stabilizes around 3%. Moreover, the underlying fundamentals for many countries and companies remain strong, and differentiation with weaker areas is growing, offering greater opportunities for skilled stock pickers.
For example, our fundamental equity team has been underweight to Brazil, Turkey, Mexico and South Africa, but had small overweights to countries like the Philippines and Indonesia due to their long-term growth drivers. The fundamental equity team is also overweight China, despite its corporate indebtedness, and India, where they see opportunities in the rural sector. At the same time, the team continues to pay close attention to whether there is adequate compensation for the increased risks. They are also cautious about the disproportionately large overweight to the IT sector in some EM equity markets.
Looking Forward: Potential Growth Opportunities for Long-Term Investors
While EM outperformance over DM has melted away in the first half of 2018, we believe both EM debt and equity markets continue to offer value, though investors need to be more discerning. Markets have moved to a higher level of risk aversion, but better global growth, stable Treasury yields and greater certainty on trade negotiations in the second half could go a long way to increasing support for EMs whose fundamentals remain sound. Many EMs remain attractive on a yield basis compared to DMs (even with higher DM interest rates) and, in our view, continue to present growth opportunities for long-term investors who are selective in their exposures and feel comfortable with more normal levels of volatility than we saw in 2017.