Geopolitical and financial risks came to the fore in May: the United States exited from the nuclear deal with Iran and went ahead with planned import tariffs on steel and aluminum, while the political crisis in Italy also roiled global markets.
Sharp currency falls in Argentina and Turkey contributed to the risk-off sentiment towards emerging markets. Emerging Asia was also in focus as central banks in the region raised interest rates to stem inflationary pressures and bolster currencies.
Despite the gloomy mood of global equity markets, we believe the current volatility is more likely an extended correction rather than the start of a bear market. If the S&P 500 recovers its upward trend, we think that other markets also will be able to find their footing.
In the short term, the US stock market may continue to hold up better than most due to strong technical and fundamentals. But over a six- to 12-month horizon we prefer to overweight Europe, Japan and emerging markets (EM).
EM equities have struggled in recent months and outflows in the last week of May were the greatest since December 2016. We believe the recent weakness is primarily due to the rebound in the US dollar from its recent three-year lows, leading markets to extrapolate a further leg of sustained appreciation.
With the dollar well above most Purchasing Power Parity (PPP) estimates and pressure building from the US “twin deficits”, we are not in the strong dollar camp; we think the dollar index is close to a peak. Once the dollar loses momentum, sentiment towards EM should first stabilize and then improve – especially if we start to see better economic data from Europe and Japan.
We are less concerned about higher US Treasury yields than the dollar. Historically, higher US yields have not been a major drag on EM performance. With US and global inflation remaining below historical trends, a gradual grind higher in 10-year yields in the second half of the year appears more likely than a sharp move higher.
Recently, a new fear has emerged for EM: that global liquidity conditions are about to tighten dramatically, given further Fed rate hikes and the progressive reversal of quantitative easing (QE). This would put added financial pressure on EM companies that have borrowed in US dollars. We think such fears are exaggerated.
Firstly, global dollar liquidity is only likely to tighten gradually: the European Central Bank and Bank of Japan, after all, have yet to exit QE. Secondly, once Chinese companies are excluded, EM corporate debt is actually a lot lower, on average, than that of US companies, while the debt burden is becoming more manageable after the recent strong growth in earnings before interest, taxes, depreciation and amortization (EBITDA).
Elevated external debt levels may reflect greater foreign ownership of domestic securities besides corporate borrowing in overseas currencies (as in the past). Indonesia’s total external debt, for example, is 35 percent of GDP but only 14 percentage points of this is corporate issuance . There will clearly be pockets of risk and potential stress points, however, since some EM corporates will have levels of US dollar-denominated debt that are much higher than average.
In Asia, many investors have expressed concern over the recent interest rate hikes in Malaysia, the Philippines, Indonesia and India. They wonder if this is the start of an uptrend in regional interest rates without which liquidity would be “sucked” away from the region as foreign investors continued to pull their money out.
We do not think Asian central banks will be forced to move in lockstep with every 25-basis-point hike in the US Federal funds rate. Historically, though, interest rates in Asia and EM have usually followed the trend in developed-market rates (full monetary independence is not possible under the present US dollar-based international monetary system, not unless a country has robust capital controls in place). We have seen relatively little change in Asia’s positive fundamentals since the markets became more volatile.
GDP growth for Asia ex-Japan in the first quarter of 2018 picked up a little, boosted by data from Hong Kong, India, the Philippines, Singapore and Thailand. The latest monthly economic data releases suggest little change in trend growth. Export numbers have been a little better, although weaker purchasing manager’s index (PMI) new export orders suggest a note of caution. Even if exports weaken in coming months, domestic demand remains firm in most Asian countries.
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