Is this sharp sell-off is just the beginning of another prolonged period of EM weakness or does it represents a buying opportunity?
- Emerging market asset classes have experienced a broad-based sell-off across regions and asset classes, similar in severity to the Taper Tantrum in 2013.
- In contrast to the first half of the decade, we do not see this as the start of a prolonged period of EM underperformance.
- Improved fundamentals, a more growth-supportive China and more attractive valuations suggest that for investors with a longer-term investment horizon, emerging market assets offer good diversification and return potential.
- Still, heightened trade tensions and a Fed set on tightening further present meaningful risks, suggesting that emerging markets are likely to remain volatile in the near term.
The importance of USD to EM investors
Typically the fortunes of emerging markets are very closely tied to the performance of the USD.
The current emerging market weakness appears to be more of a strong dollar story than a fundamentally weak EM story, at least compared to the Taper Tantrum. This may suggest that as long as the broad USD can stabilize, then EM pressures should subside.
So if broad ex-US growth can show some improvement, then emerging markets should be able to rebound.
A more growth-supportive China
Another important comparison of the backdrop for EM now versus in the first half of the decade is the state of China’s growth.
After injecting significant stimulus into the economy following the Global Financial Crisis, China reined back fiscal and credit support for the economy. In 2015, China’s nominal GDP growth fell as low as it did in the 2008 crisis and 2000 recession before the country eased policy late that year and in early 2016.
Of course, China is the world’s second largest economy, contributing somewhere between 25% to 30% of global GDP growth in recent years (World Bank). It is integral to global supply chains and commodity prices, and the collapse in China’s nominal GDP growth amplified pressures across EM over this period.
Now, China’s growth momentum is again cooling as authorities de-risk the financial sector and address pollution. This managed slowdown has been well communicated and is set to be gradual, having learned the lessons from the sharp downturn several years ago. Moreover, China’s recent cuts to its reserve requirements signal a bias towards liquidity provision and careful focus on the downside risks to growth. Having experienced something of a ‘nominal hard landing’ in 2015, China’s more balanced approach to deleveraging should ease concerns that history is repeating itself.
The bottom line for investors
While we have revised down our expectations for EM equities and EM credit for 2018, we believe that emerging market asset classes offer attractive value for longer-term investors. If we are correct that global data outside the US is likely to stabilize, that should support EM asset classes both by boosting the economic outlook and limiting upward pressure on the USD.
As evidence of this growth stabilization plays out, and assuming trade tensions cool as we expect, EM investors will be rewarded, although volatility is likely to remain heightened in the near term. And we reiterate that there remain a number of idiosyncratic opportunities and risks in specific EM countries, which we continue to position for in our EM equity, fixed income and currency portfolios.