So far, 2018 has been a difficult year for emerging market (EM) assets, which in the last few months have fared significantly worse than their counterparts in developed markets. This has been due mainly to worldwide issues but also country-specific political uncertainty. Many investors are now asking if the sell-off presents a buying opportunity – or are there reasons to remain wary?
Seeking to answer this question, several of Aberdeen Standard Investments’ senior money managers, strategists and economists gathered to share views on EMs – the risks and also the opportunities. We were joined by special guest speaker, Sir Douglas Flint, former Chairman of HSBC and now the Chancellor’s City Envoy to China’s Belt and Road Initiative, who shared some unique insights.
As a starting point for the discussion, we carried out a poll of attendees, which revealed:
- 83% believe risks in EMs are increasing; 17% believe they are decreasing
- 46% consider rising US interest rates/rising US dollar to be the greatest risk for EMs over the next 12 months; 25% say a slowdown in China is the biggest threat
- 50% believe Asia offers the best EM opportunities over the next 12 months; 20% consider Latam has greatest potential
- 64% believe EM bonds offer the best risk-adjusted returns over the next three years; 36% voted for EM equities.
The views on equities versus bonds and geographic preferences were interesting. In the Forum, we examined the arguments put forward.
The economists’ view
There have been both country-specific drivers, and worldwide drivers, of the recent EM sell-off.
Country-specific issues include increased political uncertainty, as in Brazil and Mexico. Elsewhere, there have been doubts raised about central banks’ independence from government, for example in Turkey, Argentina and Hungary. Some of these country-specific drivers are now starting to reverse.
Of greater importance has been the pressure across the EM complex from three external factors.
- Rising US interest rates and a stronger dollar – many EMs have large piles of debt denominated in US dollars – when the dollar strengthens, so too does the value of that debt. Another reason why the dollar matters is that a strong dollar can dampen world trade. Additionally, depreciation of an EM currency puts pressure on its central bank to raise interest rates, which can then slow domestic growth.
- Slowing industrial growth in China – the weakness in China’s industrial activity has been offset by strength in services, so that overall growth looks healthy. However, the slowdown in the more externally facing industrial sector has spilled over into some weakness in world trade, which affects other EMs.
- Trade protectionism – many small, open EMs are disproportionately impacted by recent trade actions. They are affected both directly through the loss of value-add provided to Chinese exporters, and indirectly through the broader move away from multi-country trade systems. Indeed, even before tariffs were implemented, trade flows appear to have been disrupted as sentiment deteriorated.
There are significant pockets of risk in Latam (e.g. over-reliance on commodity exports) and emerging Europe (e.g. slowing trade flows) while emerging Asia does not appear to be especially risky.
Our view on current EM health
EMs markets are affected to different extents by world events, depending on their strengths and vulnerabilities. We analysed the vulnerabilities and imbalances that could potentially trigger a crisis. Our work revealed that there are significant pockets of risk in Latam (e.g. over-reliance on commodity exports) and emerging Europe (e.g. slowing trade flows) while emerging Asia does not appear to be especially risky.
Importantly, we note that, although EM fundamentals have weakened slightly over the past year, they remain healthier than during previous EM crisis episodes.
Three forward-looking scenarios
- In response to the current episode of EM stress, it is possible the US may delay further interest rate hikes. This could be similar to the so-called ‘taper tantrum’ in 2013, or the year-long pause in rate rises between December 2015 and December 2016.
- Alternatively, today’s experience could mirror the temporary sell-off of early-2004 when US rates started to rise. During that period, global growth was strong enough, and the EM economies robust enough, to withstand higher US rates, and EM asset prices subsequently recovered.
- Another possible scenario is one where US rates rise faster than expected, meaning the dollar could appreciate further. Chinese industrial growth may continue to slow, protectionist trade measures build and the moderation in global growth that we are currently seeing could continue. None of these assumptions is particularly wild, and they would exert continued downward pressure on EMs.
The investors’ view
EM equities – Devan Kaloo
Following the market correction in 2015, there has been a cyclical recovery in EMs outside China. Low interest rates and improving global trade have helped boost domestic growth, a trend reflected in improving company earnings. Moreover, while initially confined to technology and commodities, this improvement has recently broadened to include other domestically-focused companies.
Looking at individual asset classes, EM equities look well-supported from a bottom-up, company-level perspective. In terms of valuation, EM equities are cheap relative to the US, although not compared to Europe or to their historic levels.
Upcoming elections in a number of EMs are likely to cause volatility. Moreover, those countries that are more heavily indebted are exposed: as central banks start withdrawing monetary support, the cost of borrowing will increase, putting the brakes on economic growth. China’s sound economic health gives it much flexibility and freedom in managing the economy. Nevertheless, given China’s close trading links with its more economically vulnerable neighbours, it is unlikely Chinese policymakers can manage these potential risks without some impact on China itself. The environment is becoming increasingly hostile, as protectionism and rising energy prices threaten to undermine potential growth in EMs. Additionally, the supply-driven rise in oil prices is negative for EMs in general. Overall, the risks for EMs are perceived to be mounting, although there are opportunities as a result of mispricing.
Our funds are currently overweight Latam, where we believe share prices more than compensate for the risks. We have neutral fund positioning in Asia and China.
EM fixed income – Brett Diment
The financial position of many EM countries has greatly improved since 2013. Among EM fixed-income assets, government bond valuations remain favourable compared with US investment-grade and high-yield corporate bonds. Of those, US$-denominated EM government bonds look expensive relative to history, but with limited new issuance this year, the backdrop should remain supportive. Local-currency EM government bonds offer attractive real yields (‘real’ meaning taking account of inflation, which is low in most EMs), and EM currencies are undervalued. EM corporate bonds should provide defensive qualities, as rising interest rates pose less of a threat to this asset class, and credit quality is relatively high.
The outside view
EM risks are increasing, but so too is the opportunity set for investors. One area of particular interest is China’s Belt and Road initiative.
Belt and Road initiative (BRI)
China’s huge, multi-year BRI aims to pave the way for trade between China and other parts of the world via land and sea routes. 120 countries have signed up to the US$900 billion project, among them many Asian and Eastern European nations eagerly seeking infrastructure-driven economic growth. By exercising a form of ‘soft power’ in creating this free trade area, China aims to decrease the environmental impact of other EMs, and to decrease forced migration by promoting prosperity. Even if only small sections of the plan reach fruition, BRI could promote connectivity between markets, economic growth and shared wealth for those involved. For countries that are not natural allies of China, BRI might also be construed as a security threat. Indeed, the US has been extending financial support to South American countries (that are BRI signatories) via North American institutions.
China hopes the stock and bond market connections that have been built will create an increasingly active capital market that can be used to fund investment. The difficulty with raising international funding is, and will continue to be, credit quality and governance standards. China recognises this and is working to develop governance and standards frameworks. Sceptics express concern over such issues as inclusion of non-Chinese firms, governance and funding, and point to the fact that there has been very little investment so far, compared with the size of the proposed project.
From his discussions with Asian counterparts, Sir Douglas says the risks are viewed as being predominantly geopolitical in nature. China is heavily dependent on the US for trade, particularly IT, and will endeavour to develop its own IT intellectual property from which revenue growth will flow. Over time, China will increasingly seek to supplant the US within international bodies, to increase its power. Concurrently, its currency will become freely tradeable. Outside of geopolitical risks, Chinese government officials understand the challenge of raising funds for the project and are exploring ways to deal with it. They also recognise the problem of excess capacity in industries like steel, which is distorting world trade.
Weighing up the risks and opportunities
There are indisputable risks for EMs that could hamper further upside over the short term. However, over a longer timeframe, there are several favourable trends that offer significant opportunities for growing numbers of EM companies. Not all of these will be winners. Moreover, the sometimes relatively weak rule of law and geopolitical uncertainty in some EMs necessitates a highly selective approach to investing in both EM debt and equity. The value of careful, bottom-up research and analysis in picking the right investments cannot be overstated.
A version of this article was previously published by Aberdeen Standard Investments on 13th August 2018