The EMpire strikes back?

By Tai Hui, JP Morgan Asset Management

Added 3rd August 2016

The outlook for emerging markets is becoming more stable as falls in currency, oil and other commodity prices - added to a soft landing for China - continue to ease, argues Tai Hui, chief market strategist Asia at JP Morgan Asset Management.

The EMpire strikes back?

Emerging markets have faced some serious headwinds in recent years, which have weighed on returns both in equities and fixed income. Although the global growth outlook continues to be mediocre, some of these challenges are easing and helping to stabilise investor sentiment.

The possible end to US dollar appreciation and rebound in oil and commodity prices are helpful to attract investors back into this unappreciated, and under-invested, asset class. Nonetheless, differentiation is crucial, where domestic politics, economic reforms, China’s ability to avoid an economic hard landing and demographic trends are critical factors in driving earnings and returns in emerging markets.

Emerging economies have suffered weak growth in recent years. China’s economic transition away from investment-dependent to consumption-driven has dampened its demand for capital goods and commodities. Soft recovery from the US and Europe has also limited their appetite for imports.

Modest growth

A lack of export momentum has subsequently put pressure on domestic corporate investment, especially for those economies with high export dependence on energy and industrial metals.

As a result, the IMF predicts emerging market real GDP growth will remain below the 2005-2015 average of 5.9%.

 Emerging markets  2016  2017
 Export volume growth   3.6%   3.7% 
 GDP growth  4.1%  4.6%

                                     Source: IMF

 Despite pedestrian growth performance, there are three things that should help to improve investor sentiment. First, the fear of capital flight, with reduced expectation over monetary tightening by the Federal Reserve and the possible end to a stronger US dollar.

The Fed is approaching policy rate normalisation with caution. Its own projection shows that the rate is expected to rise 150bps by the end of 2017. This is much more aggressive than the implied expectation shown by the futures market, but very modest compared with previous interest rate hiking cycles. As a result, the US dollar index has weakened by around 5% since the start of the year.

A weaker dollar has historically coincided with outperformance in EM equities versus developed market equities. We also note that central banks such as India and Indonesia have been cutting rates steadily in the past 12-18 months, which is a reflection of their confidence on the stability of their currencies as well as capital flows.

Second, commodity prices have stabilised. The crude oil price and the CRB Metal Index have rebounded by 32% and 21% respectively since the start of the year. The worst of commodity price rout is behind us, as supply in both energy and metals have slowly adjusted to this new price environment. This should provide some relief to commodity exporters, especially in Latin America, Russia and Southeast Asia.

Third, the Chinese economy is going through a critical economic transformation with investment playing a lesser role in driving growth, while consumption is making a solid contribution. Chinese policymakers have sufficient tools to avoid an economic hard landing in the near term, but they will also need to address the issue of high corporate leverage. Economic and market performance of emerging markets is always going to be a function of the global environment. The recent market volatility from Brexit is a good example of how temporary decline in risk influences the appetite for emerging markets.

The good news is that some of the traditional headwinds facing emerging markets in the past few years are easing and this should allow these countries a less stressful backdrop. Investors can invest selectively based on local fundamentals. Economies with a resilient external position (current account surpluses; a plentiful foreign exchange reserve), a stable domestic political environment and long-term structural growth impetus (large consumer base, cutting edge technology, competitive service sector) are likely to outperform in the medium to long run. 

 _______________________________________________________________________________________

Tai Hui, chief market strategist Asia at JP Morgan Asset Management. contributed this comment to FSA.

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