EM’s moment: Last year’s headwinds could be this year’s tailwinds
Author: Regina Chi
February 19, 2019
Could it be Emerging Markets’ moment? We believe we may be at an inflection point—the moment in time when the perfect alchemy of underlying forces could propel an EM rebound in 2019.
Strong U.S. dollar now weakening
Higher U.S. bond yields drove the dollar up in 2018, creating a difficult backdrop for EM countries which also saw a broad weakening in their own currencies. Because many EM countries borrow in U.S. dollars, their debt became more expensive, and those countries with higher current account deficits fared even worse. Meanwhile, oil prices spiked 27% in the first nine months, according to Bloomberg figures, before falling dramatically, hitting net importers of oil like India, Indonesia and the Philippines hard—a double-whammy when combined with the stronger U.S. dollar.
As we look to 2019, we see a markedly different picture developing. First, we believe that with slowing U.S. economic growth and the Federal Reserve tempering its rate-hiking cycle, the U.S. currency is poised to weaken, providing the much-needed firepower for EM economies. In fact, history shows there is an inverse relationship between the U.S. dollar and EM equity performance. In periods of U.S. currency weakness, the average return on the MSCI Emerging Market Index has been 22% over the past 20 years, figures from JPM Research show.
Growth differential swinging in favour of EM
While EM markets are characterized by rapid growth and development, gauging how asset classes will perform is tied to whether growth is improving relative to Developed Markets. In 2018, U.S. GDP peaked in the second quarter at 4.2% and JPM Research estimates it will fall 1.5% by the fourth quarter of this year—a significant deceleration. Looking ahead, we believe the so-called growth differential will gain momentum in favour of EM, by as much as 3.4%, setting the stage for a strong EM market performance.
Easing trade tensions
Trade frictions between the U.S. and China created significant uncertainty and volatility in global markets in 2018, and EM wasn’t immune since China accounts for a whopping one-third of EM’s index.
However, news that officials have returned to the bargaining table has boosted market sentiment, raising hopes that a deal will be brokered this year. Our view is that both sides do want to strike a deal, and that reaching one will ultimately come down to how amenable China will be to U.S. demands on sticking points such as technology transfer, intellectual property issues as well as compliance and verification. Meanwhile, while there have been concerns about slowing growth rates in China, we expect stimulative measures such as significant tax cuts introduced in the fourth quarter of 2018, will begin to show up in the second quarter of this year.
The longer-term play
Longer term, there are reasons for optimism, too. Many EM countries have vibrant domestic economies, driven by a growing middle class, especially in Asia Pacific countries. EM economies are also leading Developed Market economies in terms of productivity rates. In fact, productivity in EM is improving at double the rate of DM.
In other words, while many of the macroeconomic influences that sideswiped EM markets in 2018 are lifting and shifting course as we head into 2019, there are reasons to be bullish over the longer-term. We believe investors would be wise to look at EM as a long-term play.
Regina Chi is Vice-President and Portfolio Manager at AGF Investments Inc.
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Written by
Regina Chi, CFA®
Vice-President and Portfolio Manager
AGF Investments Inc.
