Emerging market outlook for 2020

December 31, 2019 08:00
Employees work on the production line at a TV factory in Shenzhen. The credit impulse in China’s economy is expected to rise further, helping drive an improvement in the global business cycle. Photo: Reuters

It has been a turbulent year for financial markets in the emerging world. Not only did investors have to contend with a sharp slowdown in China's economy in the first half of the year that spilled over to global activity, sentiment was also punctuated by political risks on a regular basis as the Trump Administration went on the warpath. Nonetheless, most emerging market asset classes have still delivered double-digit returns at the benchmark level year-to-date as political risks faded, central banks rode to the rescue and the view that there would be an upturn in China’s business cycle became evident.

The trade war may remain a thorn in the side of investors next year. Agreement on a “Phase One” trade deal, which will see some tariffs rolled back, was good news and gave a shot in the arm for sentiment. However, negotiations on Phase Two are unlikely to be straightforward, especially in an election year, and may dampen sentiment again at some point in the months ahead.

However, the trade war has been a sideshow when it came to global economic dynamics, notably in China, which we continue to expect to improve next year. Recent data have brought better news on both fronts and we expect this to continue next year. In particular, the credit impulse in China’s highly leveraged economy is building steady momentum and it may yet climb to the levels seen in 2013 and 2016. That would be an upside surprise for markets, and would help to drive an improvement in the global business cycle.

The further improvement in the global business cycle that we anticipate has important implications for asset allocation and warrants taking on more risk. After all, emerging market assets generally register better performance during the expansion phase of the global business cycle than during any other period.

The changing dynamic in the global business cycle also requires a different approach in the local currency government bond market. Indeed, markets are likely to price-out further rate cuts as the global cycle improves and eventually begin to anticipate higher rates. The unexpected pause in India’s easing cycle earlier this month may have been a first sign that our view is playing out.

Instead, investors should now focus on those local currency government bond markets that offer good carry and are likely to benefit most from foreign exchange movements if the counter-cyclical US dollar softens next year. Mexico remains an attractive option from the point of view of a large real short-term interest rate, while other markets such as Brazil offer relatively steep yield curves. We also expect Latin American currencies to fare well in the next few months.

Emerging market equities ought to benefit from the upturn in the global business cycle that we anticipate. Equities usually enjoy their best period of performance during the expansion phase of the global business cycle and have historically delivered better returns at the index level than EM fixed income. What’s more, when we overlay the relative performance on the OECD global leading indicator, we can see that the MSCI Emerging Markets Index has delivered superior returns compared to the MSCI World Index of developed market stocks during all but one of the business cycles since 1995.

Emerging market equities have already responded to better news on the global cycle, broadly in line with the improvement in China’s credit impulse. We think that the credit impulse will rise further in the months ahead suggesting there will be a fertile backdrop for EM equities in the New Year.

Meanwhile, when viewed from the top-down, valuations are not expensive. It suggests that a lot of bad news is already baked into equity prices and that, at the margin, analysts are too pessimistic about the outlook. Some improvement in earnings coupled with improved sentiment ought to allow valuations to increase and stock prices to rise.

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Emerging Market Strategist, Bank J Safra Sarasin