Thus far, 2018 has been a difficult year for emerging-market (EM) assets, which in the past few months have fared significantly worse than their developed-market counterparts. This is attributable 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 U.S. interest rates/rising U.S. 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 Latin America (Latam) to have the 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, 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 U.S. interest rates and a stronger dollar–many EMs have large piles of debt denominated in U.S. dollars–when the dollar strengthens, so 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.
Our view on current EM health
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
EMs are affected to different extents by world events, depending on their strengths and vulnerabilities. We analyzed 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 periods of crises in EMs.
Three forward-looking scenarios
- In response to the current episode of EM stress, it is possible the U.S. 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, we believe that today’s experience could mirror the temporary sell-off of early 2004 when U.S. interest rates started to rise. During that period, global growth was strong enough, and the EM economies robust enough, to withstand higher U.S. rates, and EM asset prices subsequently recovered.
- Another possible scenario is one where U.S. 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, we think that EM equities look well-supported from a bottom-up, company-level perspective. In terms of valuation, EM equities are cheap relative to their U.S. counterparts, although not compared to Europe or to their historic levels.
In our view, 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 neighbors, we feel it is unlikely that 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, it appears that the risks for EMs are mounting, although we think there are opportunities as a result of mispricing.
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 favorable compared with U.S. investment-grade and high-yield corporate bonds. Of those, U.S. dollar-denominated EM government bonds look expensive relative to history, but with limited new issuance this year, we feel that the backdrop should remain supportive. Local-currency EM government bonds offer attractive real yields (i.e., after factoring in inflation, which is low in most EMs), and EM currencies are undervalued. We believe that 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 (BRI).
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. One hundred twenty 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 U.S. has been extending financial support to South American countries (that are BRI signatories) via North American institutions.
China hopes that 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 recognizes this and is working to develop governance and standards frameworks. Skeptics 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 thus 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 U.S. for trade, particularly information technology (IT), and, in our view, should endeavor to develop its own IT intellectual property from which revenue growth will flow. Over time, we believe that China will increasingly seek to supplant the U.S. within international bodies in a bid to increase its power. Concurrently, we think that 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 recognize 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, we feel that there are several favorable trends that offer significant opportunities for growing numbers of EM companies. Not all of these will be winners. Moreover, we think that 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.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
High-yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities, and are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.