Emerging Markets

We maintain a slight underweight recommendation for emerging market equities (EM).

EM equities are most sensitive to trade uncertainty and global economic growth concerns, but also to bespoke concerns about growth in China. As such, the risk/reward tradeoff here is stark. Even with a fair bit of upside potential, the risk profile leads us to recommend a slight underweight position.

Under our base-case scenario of a trade détente and a pickup in global economic growth, we believe EM equities can post reasonable gains in 2020 despite exhibiting a somewhat tepid response thus far to the ‘green shoots’ that have propelled developed markets. Our forecast is based upon overall portfolio weights being moderately defensive, with a nod to spending our risk budget wisely. We’re comfortable the assets we look to for safety will deliver, if needed, and take risks where the upside is the greatest and risk is cheaper.

Global financial conditions are important metrics for emerging markets. Two factors in particular are foremost considerations: Chinese stimulus through financial conditions and government investment (largely fixed-asset infrastructure investment); and, the strength of the U.S. dollar. We see both of these as tailwinds for emerging market equities in 2020.

Emerging markets have been less enthusiastic in embracing the global reflation scenario because of concerns that China’s economic growth may have not yet bottomed. We believe the U.S./China trade confrontation is being assigned too much blame for the slowdown in global trade, manufacturing and China’s economic growth (as well as the broader emerging market’s). Tightening financial conditions in China started as far back as mid-2016, while trade frictions only started to pile on in 2019. We had expected financial conditions in China to turn stimulative by now; however, Chinese officials have been tolerating slowing growth more than anticipated. Although Chinese financial conditions have turned accommodative, the current stimulus is weaker than the prior episodes in 2012 and 2015 (see line chart below). 

The flow of credit in China is depicted in a line chart, with a roller-coaster pattern of three booms and busts since 2009. The current level is up off the late 2018 low, but the impulse is currently weaker than expected.

Fortunately for investors, we see the eventuality of two higher- probability scenarios driving positive outcomes – albeit with volatility (nothing new for emerging markets).

  1. Even without a further acceleration in stimulus, our first scenario expects a resilient Chinese economy where the impact from the limited stimulus already injected is aided by a détente in the trade war.
  2. The second scenario is one where the Chinese economy fails to stabilize (a breakdown in trade talks would exacerbate the situation), prompting Chinese authorities to accelerate financial/fiscal stimulus. The trade disruption will likely cause a drop in both emerging and developed market equities in the short-term, until the stimulus pumps them back up. Importantly, we believe that China has ample room to stimulate its economy further – they’re not facing a scenario where they’ve expended their stimulus and aren’t seeing results; rather they’ve deliberately held back. China’s reticence is rooted in a prudent desire to wean off the credit boom-bust cycle, not inability or a lack of resources. If this scenario features a breakdown in trade negotiations, an ancillary benefit is that roiling equity markets have been the best motivator to bring all parties back to the table.

Recent U.S. dollar strength has hurt emerging markets. However, with the U.S. Federal Reserve now on pause we believe we’re nearing the peak for the U.S. dollar and expect it to weaken, helping EM equities to rebound.

Earnings and valuations – Emerging markets offer the strongest 2020 earnings estimates of any major market (see U.S. Equity Earning Growth chart). On a valuation basis, EM equities are not cheap relative to their own history (see U.S. Equity Forward Price-to-Earnings Ratios chart), but they’re inexpensive relative to developed markets. The gap between forward P/E multiples for emerging and developed markets is well above the historical average. 

EM equities remain a riskier, high-beta asset class appropriate for investors with a higher risk tolerance and longer time horizon. EM equities could suffer greatly should a trade détente fail to materialize and/or global growth fails to stabilize. Furthermore, China is dealing with a self-styled economic slowdown that’s being exacerbated by trade frictions. Should the Chinese economy remain sluggish and/or Chinese monetary and fiscal stimulus fail to arrive (or work as planned), all equities are at risk, but especially those in emerging markets.

Bottom line: Emerging markets come with an elevated risk profile. The risks and swing factors are many, but when we weigh these factors against the ability for EM equities to outperform developed market equities under a ‘less bad than expected’ or improving scenario, this leads us to maintain our recommended weighting at low-neutral.

Continue to the Fixed Income section.

Table of Contents:

Copyright 2019 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).

This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.