Latest Emerging Markets (Unconstrained) economic and market outlook.
Economic momentum in the US remains strong. The unemployment rate is at its lowest since 2000, household spending is on the rise, and fiscal stimulus should boost growth further. Of course, strong economic momentum could be threatened by an escalation of trade tensions between the US and China, as well as allies including the EU, Canada and Mexico. Despite the current economic strength, we believe that the Fed will continue to tighten monetary policy only gradually, partly because of a lack of inflation and wage pressures, and also because of a feeling amongst policymakers that the “neutral” rate of interest has structurally declined.
We believe that the Chinese government’s focus on quality growth has enabled them to reduce risks in the shadow banking sector and get a better handle on excesses in the property market. It is also encouraging to see strength in Chinese consumption. Indeed, one of the reasons that Chinese internet companies have performed so well in recent times is that they are seen as a play on the Chinese consumer. However, with global economic momentum slowing and Sino-US trade relations turning sour, Chinese exports could start to suffer. In this scenario, we believe that policymakers would stimulate the economy in order to keep growth on target. This could damage the health of the world’s second-largest economy if China’s debt/GDP ratio starts to rise more rapidly. Of course, such easing typically has a positive short-term effect on the stock market, notably the Materials sector. The other positive catalyst for the Chinese stock market is the inclusion of domestic A-shares in the MSCI Emerging Markets index. This will force passive investors to buy these stocks, and will also oblige institutional investors around the world to consider investing in them.
Oil prices and the dollar are stronger, US Treasury yields are rising, and several EM currencies have seen sharp sell-offs. Many investors are worried that these are warning signs of further distress to come across Emerging Markets. Our view is that some countries undoubtedly face further volatility, but widespread systemic weakness across Emerging Markets is unlikely. Indeed, as discussed above, we believe that the Fed will continue to tighten monetary policy gradually. Of course, even if this proves to be the case, we have to accept that global liquidity conditions are tightening. This means that the cost of capital is rising and the competition for it is intensifying. Clearly this has the potential to impact demand for EM assets. It is therefore vital to assess the critical elements that determine investors’ appetite for exposure to EM equities and currencies during a tightening cycle, namely the position and trajectory of current account balances, inflation, real rates, external debt sustainability, and political situations. Reassuringly, the largest parts of the Emerging Markets universe now run current account surpluses. These net creditor countries are far less vulnerable to a deterioration in short-term fund flows. Two thirds of EM countries are firmly in surplus territory, notably Korea, Taiwan, China, Thailand, Malaysia, Russia and Hungary. Meanwhile, the median current account position in deficit-running EM countries has improved from -3.2% of GDP in 2014 to -1.6% today. Moreover, EM inflation rates are now at levels that are more akin to Developed Markets, and are certainly a far cry from the elevated levels of the 1990s. The median rate of inflation for Emerging Markets is 2.2%. Even in countries such as Mexico where we have seen rising inflation, our view is that CPI will now begin to fall. Despite the headlines, the debt profile of EM countries is much better today than the common narrative would have you believe. Of course debt levels vary a lot, but vulnerability normally stems from a high proportion of foreign debt needing to be serviced at a time when global liquidity conditions are tightening. Reassuringly, almost 75% of the MSCI EM universe has external debt/GDP levels below 30%. Finally, we come to politics and reform, probably the most important factor for the most troubled markets. Political environments vary significantly across Emerging Markets. For example, on a recent research trip we were impressed by how committed the Argentine government is to its reform programme. Conversely, we were struck by how Turkish governance acts as a perpetual overhang to the multiple rating of the market.
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