It was a rough and tumble 2018 for EM equities, mainly due to US dollar strength, China’s weakness, sanctions on Russia and currency mayhem in Argentina and Turkey. Even so, the risk/reward potential of EM equities in 2019 looks attractive.
Emerging market (EM) equities fell into, and remained in, bear market territory in 2018, raising the question whether in 2019, they will resume their prolonged underperformance or whether the asset class can rebound and continue its appreciation.
Exhibit 1: Performance of MSCI World index and MSCI EM index (January 2008 = 100, weekly data)
Source: Datastream, BNP Paribas Asset Management, as at 02/11/2018
To answer this question, we must determine what the principal influences have been in the latest downturn. One possible explanation is the ‘RATs’ (Russia, Argentina and Turkey) of EM resembling the ‘PIIGS’ (Portugal, Italy, Ireland, Greece and Spain) during the European crisis, or worse. Unlike the eurozone’s PIIGS, the RATs are not insulated by a common currency. The pain has been felt most acutely in Turkey and Argentina, whose currencies fell sharply as investor flows rapidly retreated.
However, in Argentina, the International Monetary Fund has boosted its credit line and the central bank shifted to a zero money growth target until June 2019 to defend the currency. The extra IMF funds come with stiff austerity requirements though, so President Macri is not out of the woods yet.
By contrast, in Turkey, President Recep Erdogan has stated that “interest rates are the mother and father of all evil” and his consolidation of power has rendered the independence of the central bank questionable, at best. Despite Erdogan’s disdain for interest rates, rampant inflation forced the central bank to sharply raise the policy rate to 24%. It appears that the market believes this is the necessary first step to rein in inflation and support the lira. However, it should be noted that the country accounts for only 0.5% of the MSCI EM index and has minimal financial linkages to the global economy. Regardless of the outcome, for EM as an asset class, developments in Turkey carry relatively little weight.
The situation in Russia is much different, but still one of concern. We believe the larger risk is a seemingly endless wave of sanctions imposed by the West. Investors worry about proposed bans on trading new Russian government debt and limits on the operations of state banks, which make up roughly two-thirds of the financial sector.
Exhibit 2: Breakdown of MSCI EM index by country
Source: MSCI, FactSet, BNP Paribas Asset Management, as at 31/10/2018
The broad weakness in EM during 2018 is likely explained by the economic weakness in China from escalating trade tensions against a backdrop of already slowing growth. Yuan depreciation has offset much of the impact so far. President Xi Jinping might delay decisive action until the ultimate goal of US policy becomes clearer. As the second largest economy in the world, China is the largest component of the MSCI EM, so it is logical to assume that China has been a significant driver of EM underperformance.
The impact of a strong US dollar has also added to investor jitters. However, the US’s relative growth outperformance is partly due to the temporary boost from tax cuts. One would expect the widening budget deficit, especially during a peaking business cycle, to limit the potential for further dollar gains.
Going into 2019, there are a number of risks, but EM countries are now generally better equipped to tackle these challenges than they were a few years ago. EM equity valuations are now at a considerable discount to those of developed markets and well below their long-term average.
This is despite the evolving EM index composition. The benchmark now includes considerably more exposure to the growth-oriented consumer and information technology sectors. We believe that alone justifies a higher valuation.
In the long term, we believe the asset class still offers favourable growth dynamics and is under-represented in global indices in proportion to EM’s share of the global population and global economic output. The opportunity is also under-appreciated as many global equity funds maintain an underweight allocation to the asset class.
There is a strong argument for diversified investors to allocate to EM equities and we believe the recent weakness presents an opportunity for those who recognise the long-term potential of the emerging market growth story.
This article is an extract from the Investment Outlook 2019. To read the full version, click here.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
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