Emerging market stocks have been victims of the noise and uncertainty that have dominated headlines this year.
Several emerging countries have been in the midst of consequential elections where the surrounding sentiment is not always market-friendly.
Argentina was forced to seek assistance from the International Monetary Fund after its currency went into a free fall, and Turkey, India, and Indonesia have had to sharply raise interest rates to fend off currency pressure. Brazil, Mexico, and South Africa may have to follow suit.
Are we in the throes of an old-style emerging market contagion? Probably not, but the strong external headwinds, combined with some weakening in local economic momentum, warrant a reconsideration of investment positions.
As the Deeper Dive article explores, world economic growth has been US-biased lately, supporting the US dollar. Over the past decade, the greenback and emerging market equities have had a remarkably stable negative correlation; true enough, as the trade-weighted USD gained some 7.6 percent this year through mid-June, the dollar-denominated MSCI Emerging Markets Index has dropped 13.4 percent.
The strong US economy, combined with higher commodity prices, has heightened concerns about inflation and a faster-than expected tightening in global monetary policy.
This has increased external funding costs and pushed up local yield curves in some emerging countries, exposing vulnerabilities in places like Argentina and Turkey, which have sizable current account deficits. While their situation is not the norm in emerging markets, the fear that other countries may also come under pressure has increased risk aversion in general.
All this has happened amid a sharp increase in the risk of trade protectionism. This month, the United States imposed tariffs on US$50 billion of Chinese imports; and because Beijing retaliated, President Trump called for tariffs on a new list of up to US$200 billion worth of Chinese goods, threatening to increase it by another US$200 billion if Beijing retaliates again.
The end result could be tariffs on US$450 billion worth of Chinese products, an amount very close to China’s total exports to the US in 2017.
Whereas the impact of the initial war of words between the US and its trading partners was limited to some markets, the increased intensity in trade hostility could now threaten emerging markets as a whole.
As the short-term outlook has become cloudier, we have closed our tactical overweight position on emerging market equities in our global and dedicated emerging market portfolios.
We are also reducing the size of our overweight on emerging market hard-currency bonds. That said, we do not recommend abandoning these asset classes, as the long-term outlook for emerging markets remains solid due to secular growth, attractive valuations, and pension funds and institutional investors’ structural underexposure to these assets.
Moreover, our house view continues to assume robust global economic growth of around 4 percent this year and the next, a moderate path of Federal Reserve rate hikes, and a rational resolution of the disputes between the US and its trading partners.
All this could lead to a snap back in the returns of emerging market equities and hard-currency bonds.
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