Year Ahead 2018 regional outlook: Emerging markets
29 November 2017
This article is part of the UBS House View Year Ahead 2018, our yearly outlook on markets. You will find investment ideas and portfolio implications in the full report.
Increasingly in tech play
Asian markets rose strongly in 2017, notching up their greatest gains in eight years as the recovery in trade and corporate profits lifted regional activity. Upside surprises to economic growth, downside surprises to inflation, and China’s steady policy hand helped sustain the regional rally amid tensions on the Korean Peninsula and a volatile US political climate.
Emerging markets have undergone a remarkable transformation in recent years. Ten years ago, the technology sector accounted for only 10% of the benchmark MSCI EM index; now its share has increased almost threefold, to 29%. By contrast, energy and materials companies used to account for 32% of the index; now their weight has more than halved to 14%. Today, four of the five largest-capitalized companies in the index come from the tech sector. We see technology remaining the fastest-growing sector in the next 12 months, with consensus forward earnings growth estimates at 20%.
Apart from the longstanding tech leaders of Taiwan and Korea, China is quickly becoming a major player in the sector as its economy rebalances. At the country’s 19th Party Congress in November, policymakers emphasized the role of innovation in driving economic growth. With continued government support, an education system that produces three million science and engineering graduates each year (five times that of the US), and abundant capital available for quality projects, the boom in technological innovation will power China’s next phase of economic growth, in our view. In India, already a global player in the IT services industry, the government is deploying technology to provide state services and improve tax compliance. The country now has the world’s largest biometric identification system, with fingerprints and iris scans of more than one billion residents.
The technological shift is not limited to Asia. Coordinated public and private efforts to foster tech startups in Chile have earned the country the “Chilecon Valley” moniker, drawing comparisons with the famous California innovation hub. Mexico has also made progress in promoting startups through the creation of the National Institute of Entrepreneurship, launched in 2013 to establish a more favorable institutional framework for such firms. Similar programs have been running in Colombia and Peru, triggering rapid startup growth in cities like Bogotá, Medellín and Lima. Given the large population in Latin America who are without banking services, a key growth area is fintech. According to Finnovista, the number of fintech startups in the region recently surpassed 1,000.
In Africa, as telecommunication markets mature, mobile phones are evolving from simple communication tools into service delivery platforms. Kenya’s M-PESA payments platform supports clients with no credit history or credit scores by using mobile payments as a proxy to assess their ability to pay a loan. M-PESA is one of the first projects that attracted venture capital funding in Africa, and Kenya came to be referred to as the “Silicon Savannah.”
Technological disruption in the coming years could increasingly stem from the emerging world. This is a key factor behind our benign medium to long-term view on emerging and frontier markets. Companies that embrace technological shifts and remain flexible enough to adjust their business models should be better placed to ride these trends in the year – and years – ahead.
Russia: Cyclical recovery, structural constraints
The Russian economy not only exited its longest recession in almost two decades this year, but economic growth, despite prudent fiscal and tight monetary policy, has also offered upside surprises. Higher retail sales and real wages boosted consumption, while investment recovered, in part because of infrastructure spending ahead of the FIFA World Cup 2018. Inflation fell below the central bank’s 4% target, leading to rate cuts, and the easing cycle has further to go, in our view. Along with broadly stable energy prices, we expect real economic growth of around 2% this year and next.
Gulf Cooperation Council: On its way to diversification
The road to prosperity beyond oil remains a critical theme for many energy-exporting countries in the Middle East, including those belonging to the Gulf Cooperation Council (GCC). Regional leaders seem to be aware that oil prices might remain low for longer, which explains the recently designed economic development plans in the region. Saudi Arabia’s Vision 2030 is probably the most prominent one; it has already resulted in significant economic and business reforms in the last two years. We think further progress across the region is likely, potentially enhancing its economic diversification and growth prospects.
But the path may be long and bumpy. Renewed pressure on oil prices, reform fatigue, faster-than-expected US monetary tightening and political tensions are key risks to monitor. Balancing the need for reform with respect for local traditions and customs is essential to ensuring a successful transition. While Kuwait, the UAE and Saudi Arabia are stabilizing, Oman and Bahrain deserve careful attention given their large twin deficits. Qatar may be able to muddle through its ongoing dispute with GCC neighbors, but regional tensions will create uncertainties.
Brazil: Elections amid economic recovery
After a three-year recession, the Brazilian economy has started expanding again and is poised to accelerate in the year ahead. The recovery was triggered by the return of political confidence and a monetary policy easing cycle that slashed interest rates by half. The government also succeeded in enacting meaningful reforms, including the spending cap and labor market laws. Still, Brazil’s fiscal situation remains so worrying that the next government will have little choice but to address it.
Mexico: Resilience amid political noise
Two major political events will help define the year ahead for Mexico. Externally, the outcome of the NAFTA renegotiation may already be known early in the year; domestically, the country will hold presidential elections in July, and local polls currently favor a candidate deemed unfriendly to markets. The results of both developments may be correlated; a successful NAFTA deal would reduce the likelihood of victory for Andrés Manuel López Obrador, and vice versa. Still, we expect the Mexican economy to display resilience to shocks, and foresee 2.2% GDP growth in 2018, compared to 2.3% this year. Our fairly stable expectations anticipate a consumption recovery that could offset weaker industrial trends dragged down by peaking US auto demand.
Asia Pacific: South Asia in the spotlight
In Asia, Malaysia and Thailand will hold general elections in the coming year. Although India and Indonesia will only conduct theirs in 2019, regional and state elections next year may have implications for fiscal policy and markets.
We expect GDP growth in Malaysia to moderate to 5.3% next year from 5.6% this year as trade-related tailwinds subside. This slowdown may be averted if the government frontloads fiscal spending ahead of the general election, which must be called by the end of August. We anticipate that the elections will be held between March and mid-May. We think the incumbent UMNO party will likely win, implying a continuation of current economic policies.
Thailand’s turn is slated for November. Although it is unclear which parties or prime ministerial candidates will be running, we think a future government will emphasize infrastructure projects, which have tended to be an issue in the past. These should present investment opportunities in infrastructure and property.
Indonesia and India will follow with their elections in spring 2019, but their governments will aim to keep voters happy in the interim. Both countries disappointed initial 2017 consensus GDP forecasts, but we expect better growth in the coming year. In Indonesia, public investment has increased to such an extent that it is now unlikely to boost growth further. We expect incremental expansion to come from consumer-related outlay, including stable pricing of power and fuel. Ten million households will benefit from social assistance such as healthcare, education, social protection funds and straight cash handouts, up from six million previously.
In India, reform programs such as those targeting the goods-and-services tax have disrupted economic growth this year, but we believe they will improve the country’s medium-term outlook. But there is a risk of fiscal slippage in the run-up to the 2019 general elections. The incumbent BJP government has become a touch more populist, with costly farm-loan waivers and farm-support schemes. Any increase in populist spending would likely support consumption, but delay the investment cycle recovery, thus lowering the potential growth outlook.