China, which looms so large in the emerging markets universe, seemed to be in a good place not long ago, with the increasing weight of A-shares in MSCI indices, an economic stimulus and an end to the trade dispute with the US seemingly in sight. But then the Trump administration upped the ante once again, putting tariffs up to 25 per cent on $200bn of Chinese imports and forbidding US companies from trading with Huawei.
This seems to indicate that there will be no quick fix to the trade war, even if Donald Trump and Xi Jinping make progress at the upcoming G20 summit. A more domestically-focused China with tighter capital controls would likely be negative for emerging markets in the longer term, while the continued uncertainty could mean increased volatility.
“These latest developments are signalling that the trade war is not actually a trade war but rather a technological or even a cold war,” says Xavier Hovasse, head of emerging market equities at Carmignac. “And it is here to stay and it will be naïve to think that it will end anytime soon. We are watching carefully how China is responding to Trumps’ deliberately provocative acts so to try to gauge the repercussions on the global economy.”
The investment firm is trying to concentrate on long-term trends in China, positioning itself on domestically-oriented companies in sectors of the “new” economy, such as consumption or services, which should have good growth years ahead of them.
Emerging Markets have been pushed to the sidelines by the trade war, warns Mr Hovasse, and with no signs of tensions calming anytime soon, it is necessary to focus on each country’s fundamentals and single out sectors and companies which can “sail through the storm, shutting out the noise”. Investors should be looking for companies with positive cash flow, long-term growth prospects and a track record of resilience in uncertain times, he explains.
“If nothing else, a bit of weakness has opened up some good entry points,” adds Mr Hovasse.
Wider issue
The trade war is just one manifestation of a bigger issue, namely the rise of China and the West’s unwillingness to accept that, believes Jeff Mueller, high yield portfolio manager at Eaton Vance Management. Even if a solution to the current spat can be found, this is part of a long running saga that will be here for some time to come, he says.
Although the effect on markets could be considerable, the impact is likely to run much deeper, warns Mr Mueller. “Companies need to look at their supply chains and so on. Do they have a portion of them in China? Can they continue to source or manufacture parts or materials there and get them out? We are seeing a number of countries saying that no matter how this trade war shakes out, we are uncomfortable having this much exposure to China and we are going to diversify.”
Although much of the emerging market universe is heavily dependent on global trade and China, and are experiencing heightened volatility as a result, other parts are faring much better, says Michael Cirami, co-director of global income at Eaton Vance.
“I like places where you don’t have to answer ‘is China going to do well, or what will the Fed do?’” He highlights Serbia, Egypt and Ukraine.
It is “worrisome” that the trade war is widening beyond trade to encompass market access, export restrictions, visa restrictions and so on, says Alex Wolf, Asia markets specialist at JP Morgan Private Bank, while tensions around technology seem certain to increase.
“As politics and security become the main priorities, the worry is that economic rationalities will become overwhelmed by political and security concerns, which could make escalation more likely,” he says.
The impact on emerging markets will not be uniform, he says, with winners and losers being created. For instance Brazil could benefit as China diverts soybean purchases from the US, while those in the tech supply chain, such as Korea and Taiwan, could be hit as disruptions and US tariffs impact Chinese demand for components.
It is unfortunate that emerging markets are all grouped together in one index, says Mr Wolf, as there are far more differences between these economies than there are similarities, and they should be viewed on a country-by-country basis.
“That’s why it’s important to understand that crises in Argentina or Turkey need not impact the rest of emerging market countries. An investor should look for countries with high levels of productivity growth, positive economic reform, good governance and a stable political climate.”
The big question in the trade wars is whether we moving from an amicable and intertwined relationship between the US and China and towards a more adversarial, stand-offish, winner takes all kind of relationship, says Olga Bitel, global strategist at William Blair.
“If it is the latter then we can potentially see a real bifurcation in standards across the globe,” she warns. “Economic standards, technological standards. Billions of products across all kinds of industries, not least technology, could be affected and you can easily see how somebody with the stroke of a pen could easily cut out lots of competitors from other countries.”
The US, which was complacent about its technological dominance, has been caught out by the rise of China, says Ms Bitel. US companies have seen lower levels of innovation and less capital being allocated to research, and as a result you have companies like Hwawei claiming they are two to three years ahead of their nearest competitors in terms of 5G technology. Leadership in 5G is absolutely key, she explains.
“The US was at the forefront of the 4G rollout, which led to all your Ubers, food delivery businesses, anything that is map driven. 5G can be even more transformative and could lead to even more innovations and new companies, so whoever has that technological edge will obviously have the first mover advantage in developing these industries, and ultimately the standards they are guided by. This is a big prize.”
Source of returns
Despite being buffeted by the trade wars, there are plenty of investors who see emerging markets as key to their long-term asset allocation plans.
“Emerging market equities are really key for us,” says Steven Wieting, chief investment strategist and chief economist at Citi Private Bank. “They are where we expect to generate the strongest, long-term returns, though there will be differences between regions, and shorter-term tactical performance.”
Emerging markets have had around a fifth of the returns of US stocks over the last five years, he explains, and many have “beaten down” currencies with as low inflation risks as the US, with the exception of the idiosyncratic outliers, the most extreme case being Venezuela. The diversification benefits are also a major attraction, he adds.
He favours Asia, which has low inflation rates, relatively cheap currencies, high saving rates, very favourable demographics, with growth in the world’s middle class over the next 15-20 years expected to be centred in the region.
Citi started overweighting its position in emerging market equities in 2016, first towards Latin America, then Asia. “Our view is that emerging market performance will be strong when the Fed is deep into an easing cycle and it hasn’t even started yet. The US is quite comfortable with currency weakness when it is trying to stimulate, and that can lead to strong and sustained returns in EMs. And we would then expect to take our modest overweights we have now and make them much larger.”
When the Fed paused its tightening programme, emerging market central banks were able to pause, or even reverse their own tightening cycles. “That means liquidity remains available, which means investment and consumption can be done, so it is a strong foundation for growth,” says Warren Hyland, portfolio manager for global emerging markets at Muzinich & Co. “It is putting more fuel in the engine, which supports emerging markets in general.”
Muzinich is a specialist in corporate credit and runs about $4bn in emerging markets. Mr Hyland says the market is at fair value at the moment, and when that is the case, the areas of value are where the volatility is.
“This is where people have the fear and the greed. At a country level, there are opportunities in countries such as China, Argentina, Turkey and Indonesia. You can look there for companies with strong fundamentals.”
Leading companies tend to be “bulletproof” and this is an area he has been adding to, buying long duration bonds to “cushion out” some of the volatility.
At a sector level, he sees opportunities in energy companies, while the outbreak of African swine fever in China has created opportunities in protein. “All the companies producing pigs outside of China are going up in value, while more people are buying chicken, and while there are less pigs there is less demand for feed, which has fallen in price, making beef more profitable.”
Muzinich is also overweight India in all of its funds, liking the stable government, the growth rate, the reform agenda, and the fact that the country is sidelined from the trade wars.
Indian safe haven
This last factor is cited by a number of investors who see great opportunities in India.
“India is the second most important country in emerging markets, and likely the fastest growing one,” says Renata Klita, senior equity analyst at London and Capital Asset Management. “It is also a relatively closed economy so the trade wars should be having lower negative impact than for smaller Asian peers.”
Prime minister Narendra Modi was widely predicted to lose his majority in the recent election, but the opposite happened and the Bharatiya Janata Party actually increased its number of seats. This should give Mr Modi a strong enough mandate to continue his reform agenda.
“India seems the best long term secular growth story in the emerging market universe and I would expect investors to return or increase their allocations,” says Ms Klita. “Unfortunately, India is not – yet – big enough to offset the negative forces elsewhere.”
Compared to its peers, India may well outperform, agrees Yerlan Syzdykov, head of emerging markets at Amundi, especially if the government can make more progress on the reform side to improve the country’s growth potential. The removal of the election uncertainty should be modestly positive for local bonds in the short term, while he believes some equity investors held back their investments due to the election.
“The continuity in the administration and economic policy is obviously welcome for equity investors and, despite the market being fairly priced at the moment, we expect premium valuations to be sustained.”
Yet not everyone agrees that the situation in India is quite so rosy. With the elections behind us, the focus in India now shifts back to the economy. Mr Hovasse at Carmignac highlights a bad loans problem which India has been dealing with for years, which took a particularly bad turn in 2018 with the collapse of infrastructure lender IL&FS. Meanwhile, consumption growth has started weakening, while lower oil prices in the past five years, have helped the government save on oil subsidies and spend on other initiatives. “Any supply disruptions in the Middle East could mean more trouble for the government’s finances,” he warns.
The international community was very excited about Mr Modi’s ascent to power, with investors warming to his reform agenda. But the reality is he simply has not delivered, says Ms Bitel at William Blair, while there have been other worrying developments. “We have seen an erosion of institutions, signs of disrespect from the Modi administration, be it the legal system, or over central bank independence, and that is a dangerous precedent.”
Small caps
Emerging market equities have been led by large cap, growth names over the last three years, which has led to a concentration of risk, believes Emmanuel Hauptmann, senior systematic equity fund manager at RAM Active Investments. This has been exacerbated by flows towards passives and ETFs.
“This has left a very appealing small and mid-cap universe. They are attractively valued as the market is not really focused on this area at the moment.”
RAM is market cap agnostic, but currently has more small and mid-caps than it has had in the last five years, at around 60 per cent.
It has overweight exposure to Asia as a whole, but is underweight China.
“You have to factor China into your allocation decisions,” says Mr Hauptmann. “But given the high levels of leverage in many Chinese companies, we find more attractive picks elsewhere in the emerging market universe.”
VIEW FROM MORNINGSTAR: Disappointing returns highlight risks of volatile emerging markets
The trailing one-year period through to May 2019 has been disappointing for global emerging markets equities.
Myriad issues, including the ongoing trade war between the US and China and tightening monetary policy in major economies, cast doubts over future global growth prospects and negatively impacted investor sentiment toward riskier assets. Indeed, the MSCI Emerging Markets Index lost 4.4 per cent during the period, while the MSCI All Country World Index gained 3.4 per cent. Moreover, investors pulled more than €6bn ($6.7bn) from global emerging markets equity funds in the year ending April 2019.
Despite the negative sentiment, there have been some bright spots within the asset class. One of the top-performing strategies for the year ending May 2019 was JPM Emerging Markets Equity, which gained 3 per cent. The strategy is led by Leon Eidelman, who comes across as a savvy investor and has proven to stick to his knitting during challenging periods.
Mr Eidelman seeks 60 to 80 firms boasting quality franchises, consistent earnings streams, and solid returns on equity. During the year ending May 2019, the strategy was buoyed by strong stock selection within financials, including Brazilian stock exchange B3 as well as India-based HDFC Bank.
Another leader was Robeco QI Emerging Conservative Equities, which rose 1.3 per cent during the past 12 months.
The strategy uses an entirely quantitative-based approach, an area where Robeco has extensive experience. The time-tested quant model mainly seeks low-risk stocks, as measured by their volatility and distress metrics, but valuation and momentum factors are also incorporated. The strategy has a predictable return profile—tending to lag during strong market rallies and lead in volatile market environments – and its strong showing in the past year is consistent with expectations.
Conversely, Fidelity Emerging Markets struggled in the trailing 12 months through May 2019 with a 5.8 per cent loss, as well as approximately €800m in outflows. Lead manager Nick Price looks for 60 to 70 quality-growth firms that exhibit strong returns on equity, good balance sheets, and reasonable valuations. While the strategy is a strong offering, it was hurt during the trailing one-year period owing to its underweighting to – and poor stock selection within – Brazil, with notable detractors including Suzano and Vale.
Overall, tough performance stretches like the trailing one-year period underscore the risks of investing in emerging markets. While investing in emerging markets has diversification and return premium benefits, it may also court volatility, and thus investors should only consider it as a supporting player in a diversified global portfolio.
Andrew Daniels, CFA, CMA, Senior Analyst, Manager Research, Morningstar
