Goldman Sachs Asset Management: Emerging Market Equities In Review

Market Background^[1]

The first half of 2018 has been challenging for emerging markets. Following an incredibly strong 2017, where EM equities were up close to 40%, the asset class fell almost -7%. Furthermore, for the first time since early 2016, EM meaningfully underperformed developed markets, which returned -0.5%. 

There have undoubtedly been some justifiable, idiosyncratic drivers of this sell-off in certain countries – for example, domestic unrest and tensions surrounding the upcoming election in Brazil, the worsening of the twin deficits and perceived unsustainable Central Bank policy in Turkey, the increase in rates in India as a reaction to the rise in oil prices and the subsequent pick-up in inflation and the worsening macro picture in Argentina. However, for the most part EM fundamentals have remained robust and the vast majority of the underperformance has arisen from a shift in sentiment toward the asset class. Almost all of the underperformance so far in 2018 has come from the decline in the multiple, with the residual coming from depreciation of EM FX.

While the weakening of EM FX can, in part, be attached to the EM-specific challenges listed above, the shift in sentiment and subsequent decline in the multiple has been driven by two key issues: firstly, the fear of faster than expected rate hikes in the US and secondly, the escalation in protectionist rhetoric and policy.

In February speculation that pace of US rate hikes could accelerate as a response to better than expected US labour market data and a sharp pick-up in inflation. At the time, Federal Reserve (Fed) Chair Jerome Powell indicated a more optimistic economic outlook in his Congress testimony, surprising markets with the hawkish tilt and sparking a sharp rise in US yield curves and volatility, and a subsequent sell-off in equity markets. While largely forgotten due to the subsequent underperformance of EM during the second quarter, EM actually held up fairly well during this period of increased volatility, outperforming developed market equities over their respective peak-to-troughs.

Since March and President Trump’s announcement of a 25% tariff on $50bn of Chinese imports, equity markets have been dominated by trade news flow. First, China responded with tariffs of “equal scale, equal intensity” – in practice, a 25% tariff on $50bn of politically sensitive US goods. More recently, the US has formally introduced tariffs on $34bn of Chinese goods and the threat of US tariffs on a further $200bn of Chinese goods continues to weigh on the asset class. This has driven outflows of approximately $20bn from EM equities, left the asset class almost 15% below its January peak, in US dollar terms, and, in line with the comments above, caused the one-year forward price-to-earnings multiple to decline from 13x to its current level of 11.3x.

Outlook

Given Trump had campaigned aggressively on a protectionist agenda ahead of the 2016 US election, some deterioration in the US-Sino trade relationship could perhaps have been expected. The pace of the escalation, however, has caught markets off guard, as many of the President’s previous threats were purely rhetoric. While the back-and-forth will likely continue, trying to predict exactly how it unfolds from here seems like a largely impossible and unproductive discipline. As long-term investors, we believe it is crucial to instead focus on the fundamental picture, which remains robust for EM economies.

First, the aggregate improvement in EM fundamentals over the past few years has been significant. Since the 2013 taper tantrum, EM economies have taken a number of necessary steps that have resulted in healthier current account balances, lower inflation and a better growth outlook.

Second, EM is a heterogeneous universe where many countries remain quite insulated from trade tensions, despite what headline numbers may suggest. Even as it relates to China, the direct impact of the total US tariffs is estimated to be a 30-50bps drag to GDP growth. Should the situation take a turn for the worse, we believe China is well equipped to pull both fiscal and monetary levers to somewhat mitigate the economic impact of ongoing trade pressures. ^[2]

Third, EM equity markets are increasingly domestic-facing. The US accounts for only 8% of direct revenues for EM companies and just 2% for those listed in China. While there would clearly be knock-on consequences if we see further restrictions on free trade, the EM earnings picture remains healthy thus far. Having been suppressed for much of the past decade, earnings have shown signs of improvement, rising over 20% in 2017 and expected to grow by over 10% this year despite the recent concerns. Encouragingly, ROEs have also been contributing positively to EM returns for the first time since 2011, as margins and corporate profitability improve.

Finally, as bottom-up investors, we have the ability to invest in a way that is meaningfully differentiated from the market. This allows us to seek out businesses that are less sensitive to political agendas and that can create value over the market cycle irrespective of how trade tensions evolve. The heightened volatility that we have observed in recent months can also create interesting investment opportunities for active managers.

A full-blown trade war would hurt export revenues and growth, disrupt global supply chains and ultimately weigh on risk appetite. However, as we stand today, EM remains resilient and the fundamental outlook for EM equities remains positive. We continue to expect an improvement in the EM-DM growth premium over the coming years – an environment that has historically correlated to EM equity outperformance. And we remain confident that the longer-term picture – whereby EM will account for close to 75% of global growth over the coming decade and in the process lift close to 1.2bn people out of poverty and into the middle income class – can continue to support differentiated, domestic-facing businesses. With the recent sell-off, valuations for EM equities are back below their long-term average and at a 25% discount to developed markets, offering an interesting entry-point to a multi-year recovery story.