Emerging Markets Quarterly Outlook

Emerging Markets: Wobbling but not Tipping Over

Equities in emerging markets (EM) posted solid gains of 7.9% in Q3, following a 6.3% return in Q2 and bringing year-to-date performance to an impressive 27.8%. However, the rally has become less even than in the first half of the year as both early August and mid-September witnessed sharp, albeit short-lived, corrections. Three factors potentially played a role: 1) the still-uncertain outlook for the US economy and, accordingly, US monetary policy, 2) uncertainty associated with the US presidency, 3) the rise in geopolitical tensions on the Korean peninsula. In addition, after a long run, some investors chose to take profits in August, triggering the first weekly outflows since March.

The US continues to enjoy robust momentum in activity, notably in consumer sentiment, retail sales and labour market data. True, the hurricanes in September provided a temporary blow to the payroll series, but indications are that payroll growth will rebound in October. The key disappointment that is holding the Fed back from more decisive action remains the relative absence of inflation at this stage in the business cycle. Accordingly, the Fed focused on the “considerable uncertainty” ahead in July, warned of “moving too gradually” in September and seemed to turn more dovish again in October when it stressed the “data dependency” of its decisions. Each turn in emphasis caused ripples in short term rates, which together with the announcement to shrink the balance sheet, produced higher long term rates and shook market sentiment towards risk assets including emerging markets, be it fixed income or equities.

Secondly, the US presidency continues to generate an unabated flow of media activity, whether because of President Trump’s callous remarks in the wake of the hurricanes, his inactivity following the Las Vegas shooting, the elimination of subsidies to health insurance companies through executive order (undermining Obamacare), rising tensions with his own administration (in particular the Chief of Staff and the Secretary of State) and the use of private email servers by his daughter and son-in-law. The President’s dark moods and erratic behaviour have culminated in a notable lack of legislative achievements since the inauguration. Importantly, this includes the much-brandished tax reform, which was once again unveiled, although in unchanged form and as short on detail as previously. President Trump intends to provide only a general outline, preferring to leave it to Congress to work out the details.

In the same vein, President Trump has failed to rein in the increasingly provocative behaviour of North Korean dictator Kim Jong-Un who increased the pace of missile tests (including two fly-overs across Japan) and claimed to have detonated a hydrogen bomb. Instead, the President has countered the North’s bombastic threats with his own aggressive and belligerent rhetoric.

While these developments have rattled EM equities at various times, strengthening growth prospects have provided a bedrock of support. This applies not just to EM as a whole, but also reflects the increasingly synchronised growth contribution from the US, Europe and Japan, which underpins a sustained recovery in trade volumes. What is more, markets have continued to bet heavily on the technology sector, which is relatively insulated from policy interference and more reflective of cyclical prospects. Asian markets in particular have benefited from this trend as well as heightened interest in the consumer discretionary sector.

Market Strategy

In recognition of these developments, our country allocation remains geared towards growth, but pays heed to recent changes in valuations. Falling inflation, accelerating growth and firmer commodity prices led us to upgrade Russia to overweight, all the more so in light of its perennially cheap valuation. On the other hand, valuations for India have remained high even as the economy has successively slowed and the much-heralded reform process has hit some speed bumps with the uneven implementation of the Goods and Services Tax (GST) and the demonetisation move. We thus downgraded India on a tactical basis to neutral for now. Brazil too is benefitting from decelerating inflation and accelerating growth. But while the ongoing unfolding of several corruption scandals impinge on the president’s political capital and thus the success of the reform process, the recent announcement of a large-scale privatisation program caps the downside. We thus move our Brazil allocation up to neutral. Finally, South Korea is undergoing a remodelling of its policy framework with President Moon implementing a new pro-growth agenda aimed at shoring up income and job opportunities for the lower middle classes. But while valuations remain attractive, recurrent geopolitical ructions provide for increased volatility of Korean stocks, threatening to quickly wipe out any gains, even after prolonged periods of calm. We thus change our overweight allocation to neutral.

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