battered EM set for a rebound?

global perspectives

battered EM set for a rebound?

Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist
Didier Rabattu - Head of Equities

Didier Rabattu

Head of Equities

After a spectacular 2017, 2018 has been a tough year for emerging market (EM) equities. Sentiment and growth fundamentals have been damaged by worries about the US/China trade war, Fed tightening and a stronger US Dollar, and a number of idiosyncratic shocks in countries such as Turkey and Argentina.

However, at the macro level, factors that were putting pressure on EM assets appear to be lifting. The wide-spread negativity around trade frictions, end-of-cycle fears and a hawkish Fed, have driven valuations to 2015 levels. This market may now reconsider this discount as major catalysts consistent with EM outperformance align.

We believe this could lead to a sustained rebound in EM assets heading into year-end.

 

US/China trade – we expect short-term de-escalation

The relationship between the US and China is perhaps the most important global geo-economic and geo-political dynamic of the current century. In recent months, as trade tensions between the two countries have escalated, it is becoming clear the issues between the US and China run deeper than trade.

So far, China has limited its retaliation to trade issues, but the US focus is widening to include non-trade areas. It appears China currently has no source of support in Washington. Republicans, Democrats, the White House and even the Multi-Nationals are now starting to deploy a similar anti-China narrative. A recent speech by Vice President Mike Pence demonstrates how US politicians are increasingly suspicious of China. It is unlikely the mid-term elections have changed the underlying dynamics of Capitol Hill given the widespread skepticism. During the Obama era, China had support in Washington when it came to several multi-lateral engagements, including the Paris deal and on Iran, but all these initiatives have been reversed by the Trump administration.

Looking forward, it is worth noting that the dominant view in international-relations circles remains that President Xi would like to avoid a “Thucydides Trap” (a popular term that describes the situation where a rising power will inevitably clash with the established order) at this juncture of Chinese long-term trajectory.

There is evidence to support this: China has so far remained focussed on narrow economic issues in its retaliation against US actions and the Xi administration has steered clear of widening its retaliatory response to include non-trade areas.

Although President Xi talked tough in recent remarks, critically, China has shown stronger willingness to engage with the US in recent weeks and has talked more openly about issues that have concerned not only the US, but also other major trading blocs (such as intellectual property and access to China’s market). We expect the upcoming G20 summit to be an important event in this regard and could lead to  more meaningful discussions down the road.

It is unlikely all the issues creating a rift between the world’s two most important economic blocs will be sorted right away. However, tangible signs of reproachment would be significant and market shaping, especially given fears of all-out war, which have started to be priced in to risky assets such as EM equities in recent months.  

 

US mid-term results are positive for EM

As we noted recently, the divided congress as Democrats take the majority in the House of Representatives is likely to be negative for the US Dollar as chances of a further increase in fiscal stimulus falls through. In addition, the current configuration lessens the likelihood of confidence-sapping tail risks, such as impeachment and tax repeal, which should help reduce uncertainty.

On the geo-economics front, although the result doesn’t have a direct influence on the US/China relationship, indirectly it may shift President Trumps’ calculus. Both fiscal and monetary policies are likely to become less supportive going forward, which raises the potential of a deeper negative confidence shock from escalating trade frictions. Arguably, had the Republicans won both houses, the Trump administration may have taken an even tougher stance.

There were no surprises coming out of the Federal Reserve’s November meeting. This should reduce fears of a more hawkish stance, which were prevalent a few weeks prior.

 

China stimulus measures are now visible and growth momentum is likely to turn positive

When it comes to the Chinese domestic economy, we have seen a significant increase in targeted stimulus efforts by the government in recent weeks.  For instance, the Chinese authorities have ramped up reserve usage in stabilizing the currency. Recent data shows CNY 120bn used, which is the highest level since Jan 2017. In addition, we have seen significant verbal jawboning by key individuals and specific policy actions aimed at stabilising the equity market. For instance, there has been a nationalisation wave of the weakest companies, which have been using shares as collateral and direct government support for the equity market via proxy purchases.

On the liquidity side, we have seen repo market injections and policy moves for credit deployment to the private sector. Fiscal policy is another tool being used by China and, based on estimates, the easing is now comparable to what we saw in the immediate aftermath of the global financial crisis.  We expect the fiscal deficit to increase to 3% next year from 2.6% in 2018. Specifically, the tax reduction of CNY 1.3tn recently discussed by the Ministry of Finance may add 0.29ppt to next year’s growth according to various policy sources.

In terms of macro data, the Chinese economic surprise index is now showing signs of a more sustained upward trend having improved from -53 earlier this year to -3 currently. This implies data is starting to surprise on the upside. The latest export/import numbers were consistent with this trend, though some weakness is expected early next year as the tariffs come into play.

All in all, we think next year’s growth in China is likely to surprise to the upside and the 6.2% growth forecast for 2019 may need upward revision as the impact of various policy moves start to show-up in data.

 

China surprise index has bounced back from extreme negative levels

China Surprise Index-01.jpg (Print)

Figure 1: LOIM, Bloomberg as at 8/11/2018
 

valuations – EM discount vs. DM looks cyclically extreme as EM macro catalysts shift

The shifting catalysts noted above imply that the valuation gap, which has opened-up after a torrid 2018 for EM, looks inconsistent with underlying fundamentals. Indeed, we think Chinese equities’ peak-to-trough fall reflects a growth hit of 1ppt+, whilst the stimulus measures being planned may add 0.5 to 0.6ppt to growth next year. The broader stability of China and the CNY is also likely to be an important positive tail wind for other EM countries, especially as countries prone to idiosyncratic risks – like Turkey and Argentina – show signs of stability following recent policy actions.

Focusing on EM equity valuations, according to our estimates, the dividend yield differential between EM and DM equities (around 0.4%) is now similar to levels seen in September/October 2015 in the immediate aftermath of the CNY shock. In our view, this prices in a significant amount of stress. Similarly, price-to-book differentials are, as extreme as they were in late 2015/early 2016, despite stronger growth and external fundamentals in a number of emerging markets currently. Again, with EM growth revisions likely to turn positive in the coming months (led by China), we think this discount will need to be reassessed by the market, and will be a major force behind a potential rebound going into year end.

 

price to book EM-DM spread continues to look extreme

EM-DM Spread-01.jpg (Print)

Figure 2: LOIM, Bloomberg as at 8/11/2018

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