August Emerging Markets Update

Monthly Commentary

September 11, 2018

Developed Markets (DM) growth is still in a good place, in our view. Unlike in 2013, DM growth is solidly above potential, led by the U.S., which is benefitting from a pro-cyclical stimulus via the tax cut. Japan appears to be shrugging off its 1H18 slowdown. Recent European data is admittedly turning a bit more mixed after showing some post 1Q18 improvement. China, being the key EM anchor, is in the middle of a targeted stimulus to offset the external shock from the trade war. We believe there will be a measured deceleration in Chinese growth, but risks of a sharp slowdown are quite limited, in our view, with ample policy tools to support growth in case of further external shocks. We also believe that the differential between Emerging Markets (EM) growth and DM growth will widen marginally over the next year, driven more by a slowdown in the U.S. with relative stability in EM growth.

Given tightening financial conditions, the market has been pressuring sovereigns with weaker fundamentals (Turkey, Argentina) and more dependence on USD funding, and sovereigns with stronger fundamentals have widened in sympathy, albeit to a lesser extent. Turkey is not the norm, and Argentina has been taking measures to stabilize its economy. As such, EM debt valuations appear cheap to us, as pockets of the market are looking deeply oversold. Spreads on the EMBI have widened out from the 2018 tights of 260 basis points (bps) to ~375bps, 20 bps wide of long term averages. Emerging Markets debt is one of the few asset classes that is trading at the wider end of its ranges; U.S. HY is now trading at extreme levels relative to EMD. Valuations between Developed Markets stocks and EM stocks are now at extreme levels as well. Earnings season has generally met expectations, although the trade tariffs remain an overhang and estimate revisions remain negative.

We do not anticipate widespread contagion, which usually goes along one or more of the following channels: trade, corporate revenues, financial sector stress, or portfolio investments. Of these, given the relatively small scale of the Turkish economy, one would be primarily concerned about banking exposure (largely in developed Europe) and further portfolio outflows. Overall, we see the solid fundamentals in EM backstopping the market from full-blown contagion. Historically, these sell-offs ultimately present attractive opportunities as often, there is a response from policymakers, and concerns over widespread contagion abate.

We would look for the following to help calm markets: 1) a stabilization in Argentina, following proactive measures to address macroeconomic imbalances, 2) a meaningful monetary response from the Turkish authorities with indications of continued follow through and/or 3) stability in growth data out of China and/or a signs of continued stimulus to support the economy. If we started to see more clarity around the Brazilian elections, we would look to potentially add risk there as well.

We feel that noise around U.S./China trade policy will linger until at least the U.S. midterms. We believe that tariffs will, at the margin, slow growth and increase inflation, but the short-term hit to growth is likely to be modest as both the U.S. and China are large economies driven mainly by domestic demand, not exports. In addition, China’s management of the CNY, in allowing it to adjust to market pressures, while “leaning against the wind” to limit volatility and overshooting, is likely to be a source of stability for emerging markets, in stark contrast to 2015-16.

We must acknowledge the risk that a serious escalation of tariffs has the potential to slow growth and increase inflation, which is generally not a positive factor for risk assets. In addition, longer-term, there are risks that the U.S. Administration’s aggressive use of both WTO provisions (national security, safeguards) and non-WTO measures (section 301) will raise uncertainty about access to export markets, hitting business sentiment and investment and leading to a break-up of some global supply chains, which could lower potential global growth. Raising the cost of production would weaken corporate profits. While this is not our base case, despite sound fundamentals, the asset class is not immune to risk-off sentiment and a global growth slowdown, and we are monitoring these developments closely.


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