Emerging market equities have had a challenging 2018 with markets down -15.7% YTD, culminating in a very weak October. Fear and political events were the drivers of the pronounced and indiscriminate sell-off, creating a challenging environment for bottom-up investors like us. As we approach the end of the year, investors begin to set their sights on 2019. With that in mind, we now provide our outlook for the year ahead.
What’s been worrying investors?
Let’s address the main reasons for the disappointing performance this year. Elevated worries about the impact of heightened US-China trade tensions certainly played a key role. Uncertainty is eroding consumer confidence as purchases of big-ticket items get delayed and companies are holding off capital expenditure decisions. China’s deleveraging is another factor that weighed on markets. Mind you, the reduction of debt was widely expected and is structurally positive, but it also caused a slowdown in fixed asset investments in the world’s second largest economy. Regulatory uncertainty in key sectors in China like internet, healthcare, education, insurance and social security contribution collection further added to investor concerns. In addition, the strong currency movements in the Argentinian peso and the Turkish lira, as well as uncertainty in the Middle East and fears about the political situation in Europe further spooked investors, causing risk aversion to rise. Meanwhile, earnings growth in the US benefited from tax cuts, which − combined with a stronger dollar − made US assets relatively more attractive in the short term. While all these effects caused investors to shift money away from EM, we believe that they are short term in nature and not structural.
Have fundamentals changed?
In light of these developments, earnings have been revised downward and valuations have contracted strongly, particularly in EM, and to a lesser extent in the US. However, from a structural point of view, growth in EM is likely to be higher again as the effects of US tax cuts will be phasing out in 2019, which should eventually lead to a reversal in fund flows. Moreover, governments in key EM remain committed to structural reforms and improvements while at the same time, corporates remain disciplined in terms of capital spending, which should cause returns on invested capital (ROICs) for EM companies to rise. For sure, China’s reform and deleveraging process will be a drag on economic growth, but it will also ensure greater financial stability and make growth more sustainable, which should eventually lead to a re-rating.
Have valuations reached a bottom?
Given the lingering US-China trade war, it’s difficult to judge whether earnings have already been cut enough. However, if we look at the Price-to-Book (P/B) or the Shiller Price-to-Earnings (P/E) ratio, we are at or near record low valuations.
What to watch?
The key catalyst for the current market pattern to improve would be a resolution of the US-China trade dispute. This would also be sensible, as both parties are bound to suffer economically from an extended stand-off. The timing, however, is difficult to predict as the government policy of China has clearly turned. Further measures or the market starting to regain confidence would lend additional support. Monetary and fiscal conditions have already started to ease, yet China remains committed to its reform agenda and opening it further. This is evident from the easing of foreign ownership restrictions, for example, in the finance or auto industry which are signs that China wants to encourage inbound investments. An example is BMW’s recently announced move to take majority control of its local joint venture with Brilliance Automotive, a China-based automaker. If the trade war continues, American companies are at risk of losing out on China’s huge domestic market. The “Red Dragon of Asia” will likely sign more bilateral trade agreements with other nations to offset a potential negative impact from the trade spat with the US. Interestingly, China and Japan have started high level talks for a long time. President Xi Jinping has pledged support for private companies through improved funding, cutting red tape and reducing taxes. The People’s Bank of China (PBOC) has already cut the reserve requirement ratio (RRR) for banks while the tax burden for individuals has been reduced. If history is any guide, we can expect further measures to boost infrastructure investments. These have been slow recently and include measures to boost consumption like subsidies and eventually looser policies for the property market.
EM equities have faced a challenging year – a perfect top-down storm driven by fear and political events. However, when sifting through the noise and taking a closer look at fundamentals, the growth prospects for EM continue to look appealing on the back of continuously robust economic growth, solid corporate earnings and attractive valuations. In fact, following the sustained pullback this year, EM equities are trading at or near record lows.
For those investors with a long-term mindset and stomach for bouts of volatility, we believe EM equities provide a rich opportunity set, as the investment case remains intact and markets, at least historically, have a way of clawing their way back.
Roger Merz is head of mtx Portfolio Management, and Thomas Schaffner is senior portfolio manager, Vontobel Asset Management