In the changed (and in some ways charged) post-Brexit environment, investors are reassessing the prospects for EM equities. They are asking, in particular, whether those early signs of a momentum shift will strengthen or fade in the coming quarters.
The trajectory of the US dollar plays a critical role. In light of our long-standing concerns about the impact of USD strength on EM fortunes, we are encouraged that the post- Brexit USD bounce has been limited. We are encouraged, too, that fears of a stall in globalization—fears that well pre-date the Brexit vote—look exaggerated.
Through all the market tumult of 2016, emerging markets, and Asia Pacific in particular, have held their own. Indeed, EM equities outperformed global equity indices during the first half of the year. In the second quarter, EM growth and earnings estimates began to signal early positive momentum—a welcome shift amid a backdrop of only modest global growth. (Along with a strong USD and weak commodity prices, sluggish growth has been one of the three major headwinds for emerging markets.)
Diminished downward pressure on earnings estimates could be seen in both the magnitude of earnings revisions and the breadth of those revisions (the number of company estimates revised up vs. revised down). In short, we see hints of improvement in earnings expectations.
Going into the Brexit vote, this tentative optimism was tempered for some investors by concerns that globalization had already stalled. Certainly, the era of rapid globalization and intensified trade that began in the late 1980s suffered a major correction in the global financial crisis. But while many have noted that trade growth has plateaued in value terms, trade integration is still deepening in volume terms. Put simply, declining relative prices of commodities and manufactured goods have exaggerated the slowdown in global trade.
More significant is the trend underway in global capital flows. Current account balances are beginning to diverge between emerging markets and developed markets. Slower growth, coupled with cheaper currencies, is prompting a rising EM aggregate current account surplus.
Any analysis of Brexit and globalization for an EM investor must ultimately focus on the central importance of the U.S. dollar. We’ve suggested that despite a sharp retracing in the dollar, the multi-year USD rally is pausing and might yet experience one last leg of appreciation. Today we are more confident that the pause will be extended, although we still expect one more upward move in the U.S. dollar. The Brexit vote and concerns about downside risks to global growth have pushed out expectations of Fed tightening. For the foreseeable future at least, it looks like a significant threat to emerging markets—a strong USD—has been defused.
After the multi-year ascent of USD, the vast majority of EM currencies remain moderately below our best estimates of fair value. But the pause in USD since the late January peak has reduced the degree of FX undervaluation for much of the EM basket. The two currencies that had flirted most recently with “hyper cheap” valuations, the Russian ruble and the Brazilian real, re-rated in Q2 along with an upward move in commodity prices. The real now tilts slightly expensive; in comparison, the ruble looks measurably cheaper.
After the Brexit vote, the USD unsurprisingly caught what we might call the “safe reserve currency” bid. Unexpectedly, though, the currency that really caught that bid was the Japanese yen. The big rebound in JPY has effectively pushed the yen back to fair value, despite Japan’s negative interest rate policy and aggressive quantitative easing.
As we distinguish among EM countries for investment prospects, we look for cheaper markets with positive trends. We like Korea, where favorable valuations and momentum have now been accompanied by relief for exporters (who benefit competitively from a rallying JPY). In Eastern European markets, we still like Turkey and Russia.
Among what we call “the reform markets” (India, Mexico, the Philippines, Indonesia), equities seem to remain fairly aggressively priced in relative terms even though several have experienced either political or policymaker change.
We view the biggest emerging market of them all, China, as essentially two markets: new China and old China. At the heart of old China are the banks and industrials, which generally have very cheap valuations. Within new China are the consumer and (in particular) technology sectors, whose stocks are priced more richly but have very positive momentum. We like selected stocks in both the old and new economies on a tactical basis.
George Iwanicki is Emerging Markets macro strategist at JP Morgan Asset Management