Investment theme #3 - Emerging markets: bottoming out

  • Written by 
  • 14/12/2016

Emerging markets (EM) assets have suffered in the wake of Donald Trump’s election victory on fears of an impending return to the disasters of protectionism. We have argued at length that a combination of constitutional restraints and economic self-interest should help mellow his various, fluid and sometimes contradictory campaign trail promises.

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Admittedly, the president does have more unilateral power on trade. Various acts, ranging from the Trading with the Enemy Act of 1917 to the Trade Act of 19741, allow the president to bypass Congress’ constitutional power to ‘regulate commerce with foreign nations’. However, as we’ve mentioned in In Focus – Trick or Treat?, the fledgling make-up of his administration indicates a less controversial trade posture. We believe that now is a good time to be tactically increasing our exposure to EM equities.

While much of the recent debate has centred on political risk, EM macro fundamentals have shown signs of mild improvement, with business confidence finding a floor (Figure 10). EM-DM (developed markets) growth differentials have also shown signs of bottoming, arresting a falling trend that has been in place since the Great Recession (Figure 11). Stabilising demand from China and recovering commodity prices have helped EM exports. Meanwhile, moderating inflationary pressures in many EM economies have allowed the respective central banks to pursue looser monetary policy. For now, China remains low down our global list of concerns – traditional heavy industries are struggling and private sector investment remains weak; however, we remain confident of the government’s ability to contain any systemic risks for the moment.

Our more positive view on the commodity complex, primarily oil, should continue to translate into a more hospitable backdrop for the various oil exporting economies, including Russia, Brazil and Mexico. The prospects for a widespread balance of payments problem and fiscal deterioration in such countries should recede accordingly.

As discussed in In Focus - Emerging Markets: Building a framework, EM asset returns are closely correlated to a handful of global macro factors such as the US dollar, US Treasury yields, oil prices, and DM equities. We currently see further upside to DM equities given the prospects for continued global economic growth. We hold a moderately positive outlook on oil as supply/demand imbalances work themselves out. However, we think that Treasury yields have more room to rise as the incoming inflation data strengthens. On balance, these inputs, alongside a neutral to mildly positive view on the dollar, suggest a moderately positive tactical outlook for EM asset returns.

Within EM, it is still to Asia that we would steer portfolio exposure. There is certainly excitement to be had in some of the more heavily beaten-up areas of the last five years. However, our convictions are highest in the regions with the most credible macroeconomic policies, where structural growth and governance are strongest and markets are most liquid and diversified. EM Asia is the region that still most readily ticks all of these boxes for us. Brighter prospects for global trade are no doubt important here, but not inconsistent with our view that the US consumer – the global economic actor where trends in global trade are most often catalysed historically – remains in good and improving health.

1 Assessing Trade Agendas in the US Presidential Campaign (Chapter 1) – Noland, Hufbauer, Robinson, Moran, September 2016