We believe the defining characteristic of emerging market equities is the inherent cyclicality of the asset class. Measured as one of 10 asset classes, over 20 years, emerging market equities have been either the best-performing or the worst-performing asset class in 15 of those 20 years. After 2017 – a year full of returns with virtually no volatility – 2018 has turned out to be the opposite: packed with volatility, and bereft of return. This makes us inherently cautious of making bold forecasts of the future.
Figure 1: A cyclical asset class
Source: Callan, January 2018.
The investment environment in 2018 has proven to be very difficult. Politically, a muscular US has rewritten the handbook on diplomacy, although some would argue said handbook was thrown out of the window entirely. The normal colourful cast of characters in emerging markets has also expanded in unexpected ways. Examples include:
Economically and financially, the end of quantitative easing (QE) has finally arrived. As the tide of liquidity slowly ebbs away, we are finding out “who’s swimming naked”, to quote Warren Buffet. Argentina and Turkey were clear culprits in this regard.
Changes in perceptions are more difficult to call, but there are grounds for concern. For ten years markets have floated on the calm sea of QE, with central bankers prepared to assist at the first sign of a twitch in the markets. Investors have unsurprisingly become complacent about risk in this environment, not least that market participants are crowded together in a slew of trades that generally offer less compelling valuations to historical averages. The unwinding of QE will be a difficult and painful experience, and there will be casualties.
Market levels are determined by two variables: economic reality and the market’s perception of that reality. The reality is that two large economies now drive our world: the US and China. The markets clearly are pricing in an economic slowdown in the US. They are fearful that a trade war and aggressive deleveraging may trigger a hard landing in China.
We are convinced that over time economic growth in China will slow, for growth to remain towards 7% per year would imply its economy doubling in size every ten years – likely impossible given the iron law of large numbers. However, we see no evidence of any imminent rapid decline in the Chinese economy.
Going forward, we believe China is likely to become a heightened focus of investor attention. The market has been extremely schizophrenic about China in 2018 and commentators have ceaselessly worried about a dramatic slowdown in the Chinese economy.
What investors have actually done, however, is subscribe to more than US$50 billion of IPOs from Chinese companies (as at end September 2018), 65% up year-on-year. This tally represents a third of all global IPO proceeds, putting China on track for the third-highest capital raising on record. China’s IPO proceeds have now been greater than those in the US for five consecutive years. Furthermore, most of the money raised has been in ‘new economy’ companies – electric cars, Internet Protocol Television or IPTV, smartphones, e-commerce related, etc. China and the US now dominate the technology trends driving our world.
In addition, the opening of China’s domestic equity market (‘A-shares’) opens up a very large, inefficient and uncorrelated investment opportunity which most global investors are only just waking up to. This emerging opportunity will drive significant investment flows over time.
Figure 2: USA GDP versus China GDP
Forecasts are inherently limited and are not a reliable indicator of future results.
Source: IMF History & Forecasts, at current prices, as at August 2018.
Value is now scarce in today’s financial markets. Since 2007, despite the Global Financial Crisis, the world has added almost 50% (US$78 trillion) to the global debt tally. Much of that debt supports today’s asset markets, either directly (leveraged property investments) or indirectly (US share buy-backs supported by borrowing). We would argue that one of the few pockets of relative value left is emerging market equities.
The current 30% discount on emerging market equities (on both trailing price/earnings ratio [PE] and price/book) compared to developed market equities offers good value in a relative sense. In an absolute sense the c. 13.4x trailing PE as at end of the third quarter 2018 has historically been a good entry point in valuation terms, generating double-digit returns on average over a three-year period (although c. 20% of the time you could also have seen negative returns even from that low entry point). Emerging markets have traded at higher valuations than this roughly 70% of the time in the past 25 years.
We fervently wish for today’s central bankers to return to anonymity, so that real fundamental investors can once again determine where value lies in capital markets. This will likely lead to much more dispersion of stock returns, in a much more volatile environment.
We believe such an environment will increase the opportunities for stock pickers such as ourselves, albeit within a riskier environment. But higher risk should mean higher return, assuming we execute our investment disciplines faithfully and professionally. We might argue in short, when the going gets tough, the tough get going.
Clearly, emerging markets have had a challenging year. Headwinds from tightening global financial conditions, US President Trump’s trade tariffs and idiosyncratic fragilities within a few emerging markets weighed on the asset class over much of 2018. More importantly, emerging market growth underperformed expectations versus the US. Going into 2019, we expect some of these headwinds to ease, and though risks remain, we are generally positive for the year ahead.
The fiscal impulse from tax cuts helped the US economy to outperform expectations, and this momentum may carry into 2019. However, our base case is for the US economy to moderate in 2019, albeit to remain strong.With the US growth outlook still healthy, the US Federal Reserve (Fed) is likely to continue its tightening cycle at a gradual
pace, given only modest inflationary pressure. Indeed, core rate rises and quantitative tightening are likely to remain a feature of 2019 and play an important role in emerging market returns. At the same time, we have yet to see any signs that US terminal rates are going to be higher than a 3.25-3.75% range.
Crucially, we think that emerging market growth will move modestly higher. Such an environment of stabilised global growth, tilted towards emerging markets, and orderly rate rises should allow emerging market bonds to outperform – historically, they have outperformed in such periods. However, risks are arguably skewed to the downside – lower-than-expected US growth could spill over into emerging markets, while strong US growth could push the Fed into raising rates faster and higher. Furthermore, from a global liquidity perspective, quantitative tightening is likely to lead to excess bond supply in 2019, which means there will be growing competition for capital in 2019.
Thus, while our baseline is constructive for emerging market debt, the global backdrop will be something of a balancing act for the asset class. We think this will be an environment where selectivity will be key.
Given its significance to the wider emerging market universe, Chinese growth will be particularly important to monitor. Here, we expect recent government measures, such as loosening credit conditions, to support the economy into 2019 and for the government to implement further easing measures should they be required. Additional intervention may well be needed, as we don’t expect US-Chinese trade tensions to be resolved in the near term. A deal of sorts between President Xi Jinping and President Donald Trump is clearly possible, but structurally we expect greater competition between the two markets. An escalation of the trade war may not just disrupt manufacturing in emerging markets, but may also impact the wider emerging market universe via China’s commodity channel.
Despite the risks outlined above, we expect emerging market cyclical growth to accelerate into 2019, given that most of the economies are relatively early in their business cycles. With the US economy likely to moderate, this should allow the growth premium over the US to improve.
Figure 1: Emerging market vs. developed market growth premium
Forecasts are inherently limited and are not a reliable indicator of future results. Source: Bloomberg, Investec Asset Management. Based on Bloomberg EM and DM economy categories and Bloomberg consensus forecasts, 30.09.18.
We believe modest emerging market growth shouldn’t be inflationary, given the amount of slack in most emerging markets. Regardless of the fundamentals, further Fed hikes will likely continue to keep emerging markets on a hiking bias overall – which may hinder growth in some markets.
Other macroeconomic fundamentals are supportive for emerging markets. Policymaking remains orthodox overall, with many governments undertaking fiscal consolidation and structural reforms. Most emerging markets have improved their fiscal and external balances significantly over the past few years, which should continue into 2019, although the rate of improvement will likely be more modest. For instance, some oil exporters have been backtracking on fiscal consolidation given the extra revenue from higher oil prices, while there has been a build-up of external debt in some frontier markets.
In our core scenario, we expect assets in general to perform relatively well. Another year of healthy economic expansion, tilted in favour of emerging markets, should help their currencies to appreciate, particularly given valuations are cheap relative to history (Figure 2), current accounts remain healthy and most emerging markets are still early cycle.
Figure 2: Emerging market currencies are cheap relative to history and an expensive US Dollar
Source: Bloomberg, Investec Asset Management, 31.10.18.
NEER = nominal effective exchange rate. REER = real effective exchange rate.
However, as we’ve seen in 2018, currencies in fragile markets, such as Turkey, that make policy mistakes will likely continue to come under pressure in 2019.
Moderate inflation, combined with high real yields on average, should support local emerging market debt. Positioning should also be supportive for local EMD – global investors remain underweight both relative to historical highs and emerging markets’ share of global debt outstanding. That said, low yielding markets and emerging markets with low real local yields may come under pressure from further Fed rate hikes and associated domestic rises.
Figure 3: EM real yields remain elevated compared to DM
Source: Bloomberg, Investec Asset Management, 13.11.18.
An uptick in growth, further fiscal consolidation and structural reforms should underpin government bond spreads. This should help spread compression to offset further US Treasury weakness and we expect significant demand given the attractiveness of the yield versus other dollar spreads. However, low-spread investment grade markets may struggle in this environment, while some of the more vulnerable frontier names with challenging external debt dynamics may also come under pressure.
Idiosyncratic risk will also drive fundamentals and asset returns, both positively and negatively. An active approach to monitoring will be needed on risks such as Russian government debt sanctions, Brazil’s pension reform, Turkey’s economic crisis, and an array of important elections in countries such as India, Argentina and the Ukraine.
2018 has proved a challenge for the emerging market debt asset class. Investors in local currency debt, in particular, have experienced difficult drawdowns over the last few years and their patience has been tested. Our view is that headwinds can potentially ease in 2019 and the structural case for the asset class remains. Over the last few years, emerging markets have made, at times, painful macroeconomic adjustments, as they have rebalanced their economies. Looking forward, on a structural basis, we see value in the asset class, particularly local debt where valuations look attractive relative to history. The asset class is characterised by improving long-term fundamentals, with low inflation, rebalanced current accounts and a more positive growth outlook. This contrasts with an expensive US dollar at a time of worsening US fiscal and external deficits and above potential growth. For long-term investors, we therefore believe it is important to remain patient and confident in the long-term structural advantages that many emerging market economies maintain over their developed peers.
Clearly, emerging markets have had a challenging year in 2018. Headwinds from tightening global financial conditions have played out against a backdrop of US trade tariffs and idiosyncratic risks in emerging markets. However, while global growth improved, the growth difference between emerging markets and the US shrank. Taken together, these factors have served to weigh on emerging market debt. Emerging market corporate debt has generally held up better than sovereign debt, partly reflecting its better credit quality and lower duration. In addition, arguably the greater resilience of the asset class also helped. It is more exposed to emerging market countries with a higher contribution to global growth and less exposed to more vulnerable frontier markets.
Looking ahead, we expect some of the headwinds – trade tariffs, overlaid with a late-stage developed market cycle, tightening US dollar liquidity and moderating US growth – to continue. Ultimately, we expect emerging market fundamentals to prove resilient. Valuations point to a significant deterioration in overall credit quality, more consistent with a global recession than a softening of growth.
While emerging market growth may have disappointed expectations, 2018 has generally delivered solid corporate growth. Although currencies have weakened against the US dollar, companies have been able to pass on most of the rise in input costs to customers, balancing price increases with protecting volumes. As such, margins remain healthy, especially for exporters and those companies with US-dollar linked revenues. Overall, earnings remain robust.
Despite this, most emerging market corporates have operated with one eye on the rear-view mirror, mindful of the downturn in 2013-2015, while navigating changing political landscapes, deteriorating global trade relations and, in some cases, currency crises. This has resulted in relatively muted expansion plans, with generally light capital expenditure and continued financial prudence leading to asset sales, debt reduction and equity raising to maintain healthy debt levels.
This general conservativeness has reinforced the resilience of those companies operating in more fragile economies, such as Argentina or Turkey. 2018 has proven to be a year of low default rates and we expect this trend to continue into 2019. Credit rating agencies are increasingly acknowledging the resilience of emerging market companies. We see increasing divergence between government and corporate ratings, as companies manage their debt conservatively while diversifying their earnings and geographic locations.
Figure 1: Low default rates likely to continue
Source: BoA Merrill Lynch, 30.09.18.
For 2019, we expect emerging market growth on balance to remain stable, with some downside risks of a softening in demand. However, given the now relative cheapness of emerging market currency real effective exchange rates (REER), we see an attractive landscape for a large portion of emerging market corporates to continue to benefit. Baseline economic growth expectations remain supportive of continued revenue growth, with margins likely to stabilise.
However, we believe it will be a year of differentiation, as emerging market currency devaluations tighten domestic credit conditions, and the impact of trade tariffs filters through. It’s also becoming less clear how long US growth will continue, leading to uncertainty over the extent of central bank rate rises. The speed of quantitative tightening adds an extra variable at a time of plentiful US Treasury issuance. These risks, alongside potential policy mistakes, suggest that caution is warranted. This base case should support credit markets by keeping US Treasury yields contained, allowing for a weaker US dollar, while providing ample global economic growth and less restrictive financial conditions to support both emerging market and US credit spreads.
China’s economic policy will also be a significant driver of returns in 2019. We expect recent stimulus to have a widespread economic effect, helping to mitigate the impact of trade tariffs and stabilise growth. However, tentative signs of a property price correction suggest the risk of a broader slowdown, given the government’s focus on rebalancing the economy away from housing related investment. Thus, we remain vigilant observers of Chinese property prices and consumer sentiment.
We believe the inclusion of China into the Bloomberg Barclays aggregate indices will have a positive impact on investment and growth in 2019, but obstacles remain. Overall, we expect Chinese growth to steady, but acknowledge the potential for a slowdown in growth to permeate across wider markets, with frontier markets the most vulnerable.
The expected general easing of growth should support fixed income assets over equities. Our base case is for a gentle moderation, rather than a broad policy-induced contraction, which suggests emerging market assets will perform well.
While risks exist, emerging market corporate fundamentals remain impressively robust, with expected low defaults to continue through 2019. However, valuations have priced in significant stress for many corporates. With the outlook for global growth still uncertain, we expect volatility to remain.
In a world of stronger growth, we expect significant spread compression, particularly in high yield bonds, while we acknowledge that slower growth should see investment grade bonds outperform. However, the reality is that across countries and ratings, differentiation of credits exists. The asset class remains diverse enough to navigate either scenario and deliver excess returns above the yield. Much of the asset class has excessive risk premia which should subside once visibility improves, potentially leading to strong returns from the asset class in 2019.
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In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). All rights reserved. Issued by Investec Asset Management, issued November 2018.