It’s been a bumpy – but ultimately positive – start to the year for emerging markets (EM). Investors had a lot to digest, from the volatile US-China trade war to numerous elections around the world. The questions are: what do we expect for the remainder of 2019? And what will this mean for investors?
We believe four themes – trade, the tech sector, politics and interest rates – will continue to dominate.
Looking at trade first, the US-China confrontation has been through many twists and turns, and agreement is proving elusive. Initially, President Trump announced 10% tariffs on over $300 billion of Chinese goods, effective 1 September. This came after a ‘truce’ had been agreed at the G20 summit in June. In response, China allowed its currency to devalue to an 11-year low. In August it also slapped an additional $75 billion on US import. Markets reeled at the news.
Can both sides strike a deal? As many commentators have pointed out, it’s in the best interest for the US and China to reach agreement. Failing to do so will create clear economic and market pressures – but competing forces are at work and a resolution will not be simple. In the US, politicians from both sides of the party-divide agree that it is time the US stood up to China. On the Chinese side, the Communist Party is unwilling to lose face in any talks, especially on the 70th anniversary of the People’s Republic of China. Hardened rhetoric has therefore made striking a deal more difficult.
Despite the challenges, we still think economic pressures will force the US and China to arrive at some sort of understanding. That said, it is unlikely that hostilities will end there and relations will remain strained. In our view, the trade spat is a symptom, not the cause, of US-China tensions. At the heart of the standoff is a strategic rivalry around global positioning, so the confrontation could run for some time. As investors, we have to consider the longer-term implications of this deteriorating relationship. This includes what will happen to supply chains, capital flows and, ultimately, the profitability of the underlying businesses.
There is a silver lining. While hostilities continue, we would expect there to be some beneficiaries. For example, companies in South Korea, Taiwan and Vietnam have all seen their sales pickup as orders have shifted from China. While the trade war is negative overall, stock-pickers might able to find one or two companies and countries that are prospering.
Tech-talk
The second issue is the tech war. Again, this is part of the wider strategic rivalry between the US and China, and was sparked by Trump’s ban on US companies using equipment made by Huawei. There are worries the ban could have knock-on effects on the 5G roll-out which, in turn, will feed through the entire tech sector. China has said it may restrict exports in response. Many US companies that sell goods to China, or depend on its technology and rare earth exports, would therefore suffer were the tech standoff to escalate further. Again, our role is to understand how this unfolding confrontation affects the entire supply chain. This includes identifying companies that could step in and take Huawei’s sales.
A dovish turn
There are positives in EM, notably around monetary policy. The US Federal Reserve (Fed) cut interest rates on 31 July. Further reductions could be likely. Lower US interest rates mean a weaker dollar, which should be positive for EM, because it removes the pressure for central bankers to protect their own currencies. They can instead consider cutting their own rates to fire up their economies. Indeed, Russia, South Africa, Brazil and Turkey all recently trimmed interest rates. Given the current environment, we expect further action from EM central banks. This will make it cheaper for companies to invest and consumers buy products, driving economic growth.
Political continuity counts
Finally, we turn to politics. At the end of last year there was considerable concern around the EM election cycle, with voters going to the polls in Brazil, South Africa, India, Thailand and Indonesia. Results, however, have seen politicians committed to policy reform either gaining power or voted back into office. In Brazil, this meant the government was finally able to push its all-important pension reform bill through congress. According to the government’s Pension and Labor Secretary, Rogerio Marinho, the revamp could save the country around US$240 billion over the next decade. This would improve operating conditions for Brazilian corporations. The senate will now evaluate the proposal.
In South Africa, we have seen a continuity of government, with voters resisting the more populist candidates. This should mean ongoing progress on reforms. Governments in India, Thailand and Indonesia are increasingly looking to boost economic growth. In India, this includes perusing tight fiscal reforms to give the country’s central bank room to cut rates.
What does all this mean for investors? Company fundamentals are good and, in some cases, the best we’ve seen in quite some time. Balance sheets and cashflows have improved, while net leverage has fallen pretty much across the board. We appear to have hit the bottom on earnings revisions. Meanwhile, valuations look cheap versus the 10-year average and the US, which is expensive. Interestingly, companies are increasingly using their excess cash to pay dividends. We expect these payouts to increase over time.
Final thoughts…
We remain relatively optimistic about emerging markets. True, the next few years will be challenging, and we expect further bouts of volatility, particularly as the trade war is likely to rumble on. However, companies are in better shape than in previous years and valuations are supportive. Importantly, central banks have started to loosen monetary policy, which is supportive of economies. In other words, EM remain a fertile hunting ground for bottom-up stock pickers.
Aberdeen Asset Managers Limited is registered in Scotland (SC108419) at 10 Queen’s Terrace, Aberdeen, Scotland, AB10 1XL, Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL, and both companies are authorised and regulated in the UK by the Financial Conduct Authority.
