03 Feb 2019

Emerging markets back on the boil in 2019?

Pedro van Gaalen

Content creator and freelance writer

After a disastrous year for emerging markets in 2018, this year could see them rally if the Fed doesn't increase rates and oil prices remain stable.

Emerging equity markets are typically characterised as high volatility, high return. Prior to 2018, emerging markets were on a run, outperforming developed markets (DM) by a double-digit margin in 2017.  

 

Since the 2008-2009 financial crisis, various emerging markets have continually offered investors robust returns. This resurgence was fuelled by several political changes and structural reforms across numerous markets, including countries in East Africa and the Asia-Pacific region.

 

According to a Franklin Templeton investment note, emerging markets are now also more resilient, with many countries holding stronger reserve positions and lower external debt today than in the past, which makes them less vulnerable to external shocks.

 

The note also highlighted the idiosyncratic domestic drivers of individual countries as a benefit. As a consequence, these countries are less correlated to one another and the global market as a whole than their DM counterparts.

 

These factors led to a standout year for emerging markets in 2017 – the strongest annual performance since 2009. In 2017, the MSCI Emerging Markets Index was up 37.28% in US dollar terms, compared to the 22.40% growth in the MSCI World Index.

2018: emerging markets rally comes to a screaming halt

While 2018 started on an upbeat note, a number of external factors stopped the emerging market bull run in its tracks. A more aggressive than expected rate-hiking cycle from the US Federal Reserve resulted in a resurgent US dollar in 2018. Those emerging markets most vulnerable to US dollar strength, like Mexico, Pakistan and South Africa faired particularly poorly in these circumstances.

 

The fallout from the implementation of US protectionist trade policies also hit hard, particularly the resultant US-China trade war, which dulled investor sentiment and resulted in large sell-offs amid rising risk aversion.

 

Additionally, geopolitical tensions exacerbated matters, with the Argentinian peso falling 52% and the Turkish lira shedding 14% in a single day as spiraling debt, questionable economic policies and the impact of increasing authoritarianism weighed heavily on the two developing nations.

 

As a consequence of these factors, emerging market (EM) stocks, bonds and currencies fell from their 2017 highs and experienced their worst annual performance in three years during 2018. When the dust settled, the MSCI Emerging Markets Index was down -14.57% vs the MSCI World Index's 8.71% loss. 

Cracks appearing in developed markets

The question is, where to from here? The IMF has revised its 2019 global growth forecast down from 3.9% to 3.5% as cracks appear in the major developed economies, with signs of a slowdown in the US, a possible 'no-deal' Brexit for Britain and mainland Europe's perennial powerhouse, Germany flirting with a recession.

 

A more dovish Fed, which has signalled a pause in its rate-hiking cycle, and improving financial conditions will benefit emerging market equities as investor risk appetite returns. In fact, following the Fed's comments in January, emerging market stocks posted their best monthly performance in nearly three years.

 

While the revised global growth forecasts may seem negative, it remains an encouraging indicator for emerging markets. An analysis from Investec shows that from 1996 to 2017, earnings growth for companies in emerging markets has averaged 19% in years when global growth has been above 3.5%.

 

A more dovish Fed, which has signalled a pause in its rate-hiking cycle, and improving financial conditions will benefit emerging market equities as investor risk appetite return.

In this regard, Asia remains the emerging market powerhouse region. While China's growth is slowing – predicted to fall to 6.2% in 2019 from 6.5% in 2018 – the economy is still a global juggernaut. India will remain the star performer, with FocusEconomics panellists estimating 7.3% growth in 2019.

 

Russian stocks also hit all-time highs in early February, as energy shares rallied on higher oil prices and growth in the country's services sector continued in January at one of the strongest paces in the last six years, according to Markit's Purchasing Managers' Index (PMI).

Emerging market opportunities

Numerous opportunities also exist within emerging markets that have diversified in the face of the prolonged commodities slump. Many of these economies are in Africa and offer significant upside  – EM equities are generally undervalued compared to developed markets.

 

East Africa, in particular, is set to deliver strong and stable growth in 2019 and beyond, offering the fastest growth in emerging markets outside of Asia. Ethiopia, Rwanda and Tanzania continue to lead the region's growth, with the annual African Economic Outlook report predicting growth for the region of 5.9% in 2019 and 6.1% in 2020.

 

But these impressive growth stats come off a low case, says Chris Holdsworth, Chief Investment Officer, Investec Wealth & Investment.

 

“Financial markets in East Africa are not as well developed as most other places in the world. There are fewer companies listed, they are typically smaller and liquidity is a major issue. The growth rate may be faster but the base is much lower too.”

 

Numerous opportunities also exist within emerging markets that have diversified in the face of the prolonged commodities slump.

Turkish share prices and the lira also rebounded significantly following the crisis in August, while greater political stability and certainty after South Africa's general elections in May should also help to return some lustre to Africa's most developed economy. The IMF expects growth to pick up to 1.4% in 2019 from 0.8% in 2018.  

 

Other emerging market opportunities exist in South America, as the Brazilian economy has been buoyed by the possibility of fiscal reform under recently-elected president Jair Bolsonaro, which should have a positive effect on performance as investor optimism grows. 

What emerging market investors need to be aware of

When it comes to weighting your emerging market exposure in a balanced, risk-adjusted portfolio, Holdsworth says: “EM equities typically provide a geared play on global growth. The positioning within a portfolio would be crafted by individual needs with regards to risk and return, but the general rule is a greater appetite for risk will see a higher allocation to emerging markets.”

 

Outside of equities, other emerging market opportunities include “EM bonds, especially USD denominated bonds, which offer a way to play views on perceptions of EM risk,” says Holdsworth.

 

However, if the US Federal Reserve decides to increase rates again in 2019, there would be a significant risk for EM equities. “The key risk is if there in increase in the Fed funds rate without a prior improvement in the growth outlook. That would see a fairly large selloff in EM equities,” says Holdsworth.

 

Looking ahead to 2019, the biggest risks EM investors should watch out for are “tightening financial conditions (typically associated with rising rates) and increasing oil prices”.

A structured product solution

The growth in EM index-tracking products in recent years has provided a potential solution to EM equity access as a broad emerging markets index offers investors exposure without the need to pick specific regions or stocks.

 

Structured products built on these indices are also growing more popular, given the risk protection that they offer. A structured product that offers some capital protection also gives investors the confidence to diversify into emerging markets with some comfort that they have reduced their downside risk.

About the author

Pedro van Gaalen

Pedro van Gaalen

Content creator, editor and freelance writer

Pedro is an experienced communicator across print and digital media platforms based in Johannesburg. He attained a communications degree from RAU (now UJ), and began his PR and marketing career in 2000 in the motoring sector. He has built a career as a communications consultant and freelance writer, offering his experience, varied expertise and diverse background to various PR agencies, corporate clients and research houses.

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