Industry Voice: Krishan Selva, Client Portfolio Manager at Columbia Threadneedle Investments, says the main risk for emerging markets is in relation to the global trade war. However, negotiations will continue and the recent market correction provides an interesting allocation decision to actually favour EM.
At the beginning of 2018 there was euphoria in emerging markets, following a strong 2017. This was driven by strong earnings growth, with consensus earnings growth for the MSCI Emerging Markets index rising to 22.7% in December from 14.1% at the start of the year. Chinese equities had an exceptional year, with the market rising by over 50%. Unfortunately, this euphoria did not last and 2018 saw the MSCI Emerging Markets index fall by more than 25% from the peak in January.
In February and March, global stock market volatility affected emerging markets, with concerns over tech stocks, rising US inflation, higher interest rates and a potential economic slowdown. Emerging markets fell during this period, but by no more than in Europe, which demonstrated that their economies were healthier than in the past. Typically, current accounts were in surplus, foreign exchange reserves were stronger than before and, importantly, the majority of debt was domestically held (eg, 70% of debt in Asia is local).
But then Donald Trump imposed trade tariffs on China and everything changed. Initially, the tariffs were levied on just $50 billion of Chinese exports, which was containable. This level represented 0.01% of Chinese GDP. More recently, Trump raised the target to a less manageable tariff of 10% on $200 billion of exports, and he threatened to increase it to 25% on all Chinese exports.
Uncertainty has rippled out across Asia and other emerging markets. Many businesses have been drawing down inventory and reducing capital expenditure, which will reduce economic growth. China's export volumes haven't felt the effect yet, but are likely to show weakness in the first quarter of 2019. Interestingly, China's exports to the US are less than 3% of its GDP, but they are capturing 100% of the headlines.
As if this were not enough, 2018's tightening of global liquidity contributed to currency crises in Argentina and Turkey. The former sought a loan from the IMF while the latter faced sanctions and huge capital flight.
Looking to 2019, emerging markets still face the risks of tightening financial liquidity and trade war but there are reasons for cautious optimism. As the US Federal Reserve has raised rates, central banks in emerging markets have responded pragmatically, but all this tightening (external and internal) will put a ceiling on growth. Five or more Fed rate hikes through to 2019 could create a problem for emerging markets. But given the recent signs of a slowdown in the US economy, it is more likely that there will be two or three hikes, which financial markets have already discounted.
Trade war is the greater risk, especially if it becomes a cold war, which could change how the global economy works, altering the structure of supply chains and so on. In the case of a cold war, with globalisation changing it's hard to build a case for risky assets. But a trade war seems more likely, and in that situation market volatility is likely to continue. We expect both positive surprises as well as realistic challenges for the first six months of 2019 before China and the US ultimately strike a deal. Rhetoric from China's leaders suggests that they are ready to compromise, and President Trump likes brinkmanship, as he has shown in North Korea and with NAFTA.
Focusing on quality stocks
But we are not betting on a deal. Instead, we are increasing the quality of holdings, focusing on stocks with limited downside yet potential upside. For example, we have sold technology stocks that are in the firing line of a trade war even if the company's prospects otherwise appear promising.
Higher quality holdings include Indian financials. Following a string of defaults by non-bank financial companies, Indian credit and liquidity has tightened leading to declines in financial companies' stock prices. But our funds are invested in some private banks with strong deposit franchises. These private banks, which are investing into technology and signing up many new customers every month are gaining market share from the non-bank financials. Further, India is a more insulated economy, making it relatively protected from trade rhetoric. Hence, this theme fits the bill with limited downside and higher potential upside.
Alternatively, after the Brazilian election in 2018 president-elect Jair Bolsonaro's economic policies and the team he has put in place have been well received by financial markets, with an emphasis on cutting spending and reducing taxes. For example, pension reforms will continue to address the large fiscal deficit. Much like India, the economy is more domestic in nature and thus is less exposed to the trade war.
Even a few exceptional companies at the epicentre of the trade war are still interesting and providing great opportunities. Shares in the Chinese tech company Tencent have fallen almost a third since peaking in early 2018, yet the long-term story appears just as compelling. Apart from the trade war's implications, Tencent faces challenges from new regulation of online gaming, accounting for about 60% of its revenues. But it has created an eco-system on the WeChat app, the ‘super app' through which Chinese consumers can pay for everything from taxis to utilities and restaurants. Tencent is, therefore, in a powerful position to collect payment data, which is valuable when sold to advertisers and could change its revenue mix. We'll leave discussion around the cloud and Artificial Intelligence to another occasion.
A better year?
The two risks on the table are the trade war and global liquidity tightening.
With regards to global liquidity tightening, this ultimately puts a ceiling on growth. However, we would argue this risk is very much on the table and has two real paths - determined by the trajectory of Fed rate hikes. Many market participants have a base case of the US economy; slowing would lead to the Fed pausing its trajectory of tightening. In such an environment, the market would expect to see a weakening dollar and if 10-year bond yields are at current levels or lower would be supportive to EM - certainly creating a better relative performance backdrop in 2019 compared to 2018.
The main risk on the table for us is in relation to the trade war. At this stage, it is difficult to make a convincing argument to increase allocation to EM, but we believe the path of negotiations will continue and the recent market correction provides an interesting allocation decision to favour EM. After all fundamentals have been relatively resilient, we continue to find companies that report robust earnings and relative to many developed markets growth projections are more appealing.
Just as 2017's euphoria was a poor indicator for 2018, so 2018's travails do not necessarily set the trend for 2019.
To find out more visit columbiathreadneedle.com/insights
Important information: For investment professionals only, not to be relied upon by private investors. Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. The analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. This material includes forward-looking statements, including projections of future economic and financial conditions. None of Columbia Threadneedle Investments, its directors, officers or employees make any representation, warranty, guarantee or other assurance that any of these forward looking statements will prove to be accurate. Issued by Threadneedle Asset Management Limited (TAML). Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies