Latest Emerging Markets (Unconstrained) economic and market outlook.
The US economy continues to perform well, boosted by aggressive tax cuts, which have resulted in a $200bn earnings improvement for US companies. However, the positive contribution to growth from fiscal stimulus should fade through 2019 and 2020. Meanwhile, political uncertainty is rising. If polls are to be believed, the Republicans are heading for a heavy defeat in the mid-term elections. According to leading election statistician Nate Silver, there is an 80% chance that the Democrats win control of the House of Representatives. This would not only increase the probability of Trump being impeached, but also likely lead to political gridlock, with Trump unable to implement any major policies. As US growth begins to fade and political uncertainty increases, markets will likely begin to shift their focus to lower relative rate expectations and a rising fiscal deficit that is expected to be 5% of GDP in 2019. This should ultimately crimp dollar strength.
In China, sentiment has been damaged by trade uncertainty, tighter regulation, and a reduction in credit through a crackdown in shadow banking and peer-to-peer lending. The government has responded with some policy easing, but these moves have thus far felt uncoordinated, with tax breaks for corporates and consumers, immediately followed by a social security clamp down. However, the government is now making a more concerted effort to stabilise sentiment, with various measures to boost infrastructure investment as well as tax rebates and waivers. Moreover, in a recent research trip to China, we met officials from the People’s Bank of China and they made it clear that China has the tools and willingness to offset any further weakness in the property sector.
Argentina’s IMF funding package makes the prospect of a default very unlikely over next 12-18 months. This should give the country breathing space to move to a primary surplus, eliminate the current account deficit, and reduce inflation, creating a virtuous economic circle. Indeed, the current account deficit should see a big swing as harvests recover following the drought and the devaluation of the peso boosts exports and crimps imports. Despite the extremely challenging external conditions, we believe the authorities have responded soundly and that equities are discounting an overly pessimistic scenario. The key question is whether the Macri government will survive the November 2019 elections. This is vital as the governing coalition is firmly committed to the IMF programme. While Macri’s popularity is likely to fall further as inflation soars and an austerity-induced recession puts pressure on real wages, we still believe that he will be a viable candidate in the next election. If not, we expect the coalition to put forward an alternative candidate, the popular governor of Buenos Aires, Maria Vidal.
EM investors are currently preoccupied with three key issues: trade wars, a strong dollar and uncertainty around Chinese policy. In terms of the trade war between China and the US, it now seems less likely that the countries will reach a deal. In our view, China could be interpreting some of the recent statements by the US as implying that Trump’s primary goal is not to make trade fairer, but rather to prevent China from closing the technological, economic and military gap with the US. Clearly this goal is fundamentally unacceptable to Beijing, and so the country may seek to offset the impact of the trade war rather than strike a more conciliatory tone. The overall effect on Chinese GDP is expect to be -0.5 to -0.7%. The authorities will likely seek to offset this with stimulus measures such as higher infrastructure spending. The negative impact will also be mitigated by the fact that many supply chains are entrenched in Greater China and it will be difficult for buyers in the US to quickly shift suppliers. Thus, while an escalating trade war is a clear risk, in theory it is manageable. The US dollar has been strong this year, which tends to be bad for risk assets generally, and especially EM. This is the result of a strong US economy relative to the rest of the world. However, as discussed above, we believe that US growth will begin to slow as the impact of the fiscal expansion fades. At this point, investors are likely to focus on the country’s twin deficits and the dollar should weaken. Finally, there is uncertainty about Chinese policy, particularly around how much Beijing will stimulate the economy and whether this will increase risks by exacerbating financial imbalances. While China is now loosening policy again to offset the impact of US tariffs and a slowing economy, the government does not seem keen to engage in an all-out 2009 style stimulus package, which would increase debt levels and systemic risk. Similarly, the authorities made it very clear that they will not let shadow banking get out of control again. Encouragingly, they do seem determined to continue with the positive reforms relating to the environment and supply-side consolidation, which should ultimately boost corporate profitability.
Thus, while there are clearly risks for investors in EM equities, they would appear to be manageable and short term in nature. In the longer run, the many attractive qualities of the asset class should shine through. Indeed, emerging economies will increasingly be the engine of global growth in the future. According to the IMF, emerging economies will grow at a rate of 5.1% in 2019, compared to 3.9% for the wider global economy. Finally, EM equities are now 25% below their 2007 level, despite EM GDP having approximately doubled since then. In our view, this represents a more attractive entry point into Emerging Markets than the ‘taper tantrum’ in 2013.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).