- Emerging Markets (EM) face high uncertainty due to US equity market volatility and trade wars.
- Yet we believe EMs as an asset class looks attractive as they are quite undervalued.
- Quality has been out of favor in the EM markets in 2018, but we anticipate a reverse to the mean in the near future.
Emerging markets are one of the few asset classes where informational inefficiencies provide a fertile ground for bottom-up stock pickers (i.e., active investors) to add value. In our opinion, demographics, technology, decreased reliance on commodities and globalization all provide visible long-term growth potential.
Near-term prospects are mixed
In the near term, many emerging markets are under pressure from rising US interest rates and capital flight. As a result, countries with high current account deficits and large US dollar debts (such as India, Indonesia and Turkey), have seen sharp devaluations of their currencies. On the flip side, oil-producing countries and others that are mostly isolated from the issues noted above are holding firm, such as the Middle East, Chile, and Thailand. Notwithstanding, with the exception of China, we are not overly concerned about most EMs. The current problems are not structural and may be helped by a weakening currency as we witnessed last year in Egypt and in Turkey very recently.
Currency depreciation, rising interest rates and high oil prices put pressure on the balance sheets of governments with large trade deficits and corporations carrying dollar-denominated debt. For investors, this combination means weakening fundamentals in the near term and a drag on returns in US dollar terms.
The trade war between the US and China threatens Chinese demand and growth — this will potentially hurt the earnings of both Chinese companies and countries that export to or benefit from demand from Chinese consumption. Furthermore, the unprecedented surge in household debt leverage in China1 (doubling since 2014) has brought the debt service-to-disposal income ratio of Chinese residents to over 100%. In our view, this level severely threatens growth in consumption in the next few years. From an equity market prospective, the correction of large tech stocks in the US has pressured global tech sector valuations, in particular for a few Chinese companies with the largest weighting in the MSCI EM index. Growth of these companies has also slowed due to the maturity of their segments and soft demand resulting from a weakening economy.
India’s macroeconomic environment is looking fragile due to a twin deficit problem — the current account deficit is widening due to increased spending on oil imports. The fiscal deficit is also rising due to high fuel subsidies and pressure on the government to spend more ahead of the 2019 national elections. These twin deficits, combined with capital outflows (due to rising interest rates and better economic prospects in the US) have led to a sharp decline in the Indian rupee. This depreciation should help improve the competitiveness of Indian businesses, although in our opinion, the government should improve the competitiveness of the export sector to help bring down the current account deficit. India’s political environment is also uncertain, as any unfavorable outcome in the 2019 general elections (e.g., lack of majority government) is expected to weigh on the equity markets.
Indonesia (like India) is facing the issues of a widening current account deficit and declining currency, although not to the same extent as in 2013. Bank Indonesia’s response — increasing interest rates to stem the currency decline — has been effective. The government has also raised import duties to reduce the current account deficit. We anticipate that there will be some impact to the economy from rate increases, but the corporate sector is healthier than in 2013 and should continue to grow, in our view, albeit at a slower pace. Indonesian President Joko Widodo is a frontrunner to win the 2019 presidential election, which should be welcomed by the market given his business-friendly political standing.
Despite the decline in the peso due to capital outflows, the Philippine economy is expected to grow strongly, helped by government spending on infrastructure projects. The business process outsourcing industry, as well as domestic consumption derived from overseas remittances, will likely receive a boost from the falling peso.
Thailand is undergoing a broad-based economic recovery fueled by domestic and external demand. The Thai baht has outperformed other EM currencies due to the country’s current account surplus, low inflation and high foreign exchange (forex) reserves. Thailand is also inching closer to long-delayed elections in 2019, which should result in a stable democratic government after four years of military rule.
In Malaysia, the new government is taking steps to fight corruption, improve fiscal discipline and drive balanced gross domestic product growth from private sector participation and domestic consumption. High oil prices will help improve the fiscal deficit situation, but the government is expected to increase taxes and sell stakes in government-linked companies to raise revenue. Malaysia is likely to maintain its current account surplus through export-led growth, which together with high forex reserves should protect against sharp declines in the ringgit.
Although Brazil’s economy has yet to show signs of a meaningful recovery after its great recession, the upcoming presidential elections may be a starting point for the country’s new long-term direction. The ex-army captain Jair Bolsonaro will have to act quickly to pass desperately needed fiscal and pension reforms. Under this scenario, we believe we could see an improvement in business and consumer confidence in a period where inflation and interest rates are at historic lows. This should spur private investment and lead to stronger consumption and a better economic outlook for 2019.
Argentina had a promising start to the year, but the country’s fiscal and monetary policies were unprepared for the currency impact of rising US interest rates. The sharp devaluation of the peso and runaway inflation forced the central bank to significantly hike interest rates and, as a result, the economy has fallen back into recession territory. We believe consumption will remain weak in the first half of next year, but we expect to see a slight improvement in the second half as President Mauricio Macri’s administration works to stabilize its currency and inflation. This should pave the way for monetary easing.
Chile benefited from a strong economic recovery this year driven by a new government and higher copper prices. We believe Chile’s strong economic performance will continue next year, but we expect it to decelerate slightly given international trade tensions, lower copper prices and rising rates in other parts of the world.
Mexico’s volatile performance in 2018 was driven by uncertainties surrounding the USMCA agreement that replaced NAFTA, and a newly elected but unpredictable populist president. Typically, government spending is slower in the first year of a new administration but tends to pick up during the following years. This will likely be the case for Mexico next year, in our view. As private investment is linked to government spending, economic activity and consumption may decelerate in 2019 compared to the strong results over the last several years.
Russia’s volatility is mainly driven by geopolitical tensions and levied sanctions, although higher oil prices have been a boost to economic activity this year. Going forward, there will be a period of fiscal tightening, as authorities have raised the value-added tax by 2% (to 20%) and raised the minimum age for social security benefits. We expect these two factors to weigh on consumption in the first half of next year. Tight monetary policy should contain inflation, while increasing government spending on education, health care and infrastructure should stimulate mid-term growth. However, Russia may face additional sanctions in the coming months — this could lead to a more cautious approach to our weighting of this country in the portfolio.
Turkey faced a multitude of challenges this year as the government’s attempt to stimulate the economy through easing credit led to an overheated economy, increasing inflation and a significant currency devaluation. In an effort to tame inflation and strengthen its currency, the central bank quickly hiked interest rates. These measures have impacted business and consumer confidence and are expected to significantly slow economic growth next year. Banks have overextended their lending capabilities and we will likely see private sector loan demand dry up.
A struggling economy in 2018 put pressure on South African government finances and led to a depreciation of the rand. The new president is cracking down on corruption and introducing business-friendly economic reforms, which should boost business confidence and private investment while stimulating economic growth. The pace of structural reform implementation and the level of policy credibility will determine the extent of any economic recovery.