Emerging Markets Quarterly Outlook

Belated Honeymoon for Emerging Markets

Brimming with optimism, markets have risen to new record highs as the financial crisis recedes in memory, cyclical indicators increasingly point to a gathering global recovery and the Trump administration has proven unable/unwilling to make good on its most disruptive campaign promises. This has particularly benefitted emerging market (EM) equities, which enjoyed the additional boost of strengthening exchange rates as the dollar weakened during Q1. Similarly, sovereign bond issuance by EMs hit an all-time quarterly record in the first quarter, while flows of portfolio capital into EM stocks have also been strong. Whereas investors withdrew nearly $30bn from EM stocks and bonds in November 2016, the month of Donald Trump’s election victory, outflows slowed to a mere $1.2 bn in December and reversed to the tune of an estimated $12 bn in January.

To be sure, signs of improvement abound, not only in the context of the dismal recent years. True, Russia and Brazil are merely exiting a painful recession and remain hostage to the vagaries of local politics and global commodity prices. Political flashpoints also exist from Turkey to South Africa to Thailand. But robust economic readings elsewhere, be it in South Korea or Mexico, suggest that the broader growth downtrend of the past years may be about to be broken. Some countries, such as India and Indonesia, also enjoy large domestic economies and ambitious economic reform programs. And finally, while EM inflation is ebbing away, global trade is witnessing its fastest growth rate in seven years.

But what of the threat of rising US rates? Their impact is likely to be less damaging than in past episodes. First, the tightening cycle only responds to (and in fact, deliberately lags) the recovery of the US economy. Second, it is the most telegraphed series of rate increases in Fed history, and they are set to be both small and slow. The Fed continues to see the equilibrium real rate as near zero and has not changed its view of the terminal rate of 3.0%. Third, at the same time China’s economy is stabilising and delivering a positive growth impulse to the global economy. And finally, as pointed out previously, emerging markets possess much improved national balance sheets and more competitive exchange rates compared to previous episodes of rising US rates.

But is buying into risk at this stage in the market cycle picking up pennies in front of a steamroller? Potentially. The shock value of last year’s two seminal events – the ‘Brexit’ vote on June 23rd and Donald Trump’s election on November 8th – may have faded, but the long term repercussions of these events have yet to make themselves felt. At a minimum, the increasing scepticism about trade, financial integration and international cooperation amongst policymakers does not warrant market volatility levels near historic lows and stock markets near historic highs. While low volatility can partly be explained by record low bond yields which support appetite for alternative assets, the long term consequences of these political risks appear insufficiently discounted. While the old adage holds that ‘in the long term we are all dead’, any upsurge in US trade protectionism, in particular with respect to China, has the potential to severely disrupt appetite for EM assets.

Market Strategy

Against this backdrop, our approach remains to acknowledge both the fundamental and cyclical improvements in emerging markets, but to stay wary of current market exuberance, which relies excessively on the notion of ‘Trumpflation’. In other words, while the MSCI EM outperformed the MSCI World by a strong 4.9% in Q1, we do not indiscriminately ramp up risk exposure in our allocation. Instead, we add risk where we see value and make some other adjustments.

Specifically, we have upgraded Mexico from underweight to neutral given both the proactive stance of Banxico in stemming peso weakness and rising inflation expectations and the receding threat of a wholesale dismantling of NAFTA by the US. We upgraded Korea to overweight as the ouster of President Park opened the door to a more certain and promising outlook, while valuations remain attractive. Similarly, we moved Taiwan and Malaysia from neutral to overweight, the former on the basis of an uptick in external demand and the latter on the basis of a recovering domestic outlook.

By contrast, after a spectacular but short-lived run, we downgrade Russia from overweight to neutral as there has yet been little fundamental improvement, political tensions, both domestic and international, are intensifying again and valuations have become unattractive.

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