What has been rattling emerging markets?

Emerging markets have faced a perfect storm recently with many of their shares, bonds and currencies taking a battering. In fact, year to date emerging markets stock markets are down 8.8% in US dollar terms – but we still believe there are opportunities for investors. In this article we look at the reasons behind this recent wave of volatility, and those fund managers who could weather the storm and deliver for investors in this sector.

Concerns about slowing Chinese growth

China is the second-largest economy and the manufacturing hub of the world. This means that the country has a major impact on global growth, sentiment and appetite for broader emerging market investing.

Concerns about the rapid expansion of debt in China have been brewing for years. Chinese authorities have tacitly acknowledged this by taking measures to curtail credit growth, but this in turn has had a lag effect on Chinese economic growth which has unnerved investors.

Several weeks ago the People’s Bank of China turned the taps back on again, releasing over US$100 billion of credit for banks to lend to businesses, but this has yet to calm investors’ concerns.

US dollar strength

The US has already begun monetary tightening, with the Federal Reserve expected to raise interest rates twice more this year while also unwinding the massive balance sheet it built up through quantitative easing. These measures could quicken if the US economy overheats and inflation rapidly increases.

The consequences of US monetary tightening – a stronger US dollar and rising US Treasury yields – are particularly painful for emerging market corporates and governments which have issued US dollar-denominated debt. This is because the cost of servicing interest payments on the debt rises, therefore leading to a higher chance of default.

International investors are also pulling money back into US dollar assets, causing capital flight from emerging markets and weakening emerging market currencies. This has put pressure on emerging market Central banks to raise interest rates and tighten monetary policy, and we have already seen Argentina and Turkey’s Central banks take action.

Global trade wars

Global trade tensions have escalated dramatically recently. They began with the US implementing 25% tariffs on a list of Chinese goods with an import value of US$34 billion, to which China retaliated with its own 25% tariff on 545 US goods, also with a total value of US$34 billion. The US already has another US$16 billion of tariffs in the pipeline, and has threatened a 10% levy on a further US$200 billion of Chinese goods including clothing and household appliances.

While the actual tariffs already implemented are estimated to have a fairly marginal impact on GDP, the perceived risks of an all-out trade war has caused alarm. For the Trump Administration, this may all be a game of brinksmanship to get a ‘deal’.

He is surely mindful that his ratings have been improving steadily this year as the US economy is firing on all-cylinders, tax cuts kick in and the stock market is being boosted by record share buybacks, so jeopardising this through a trade shock is a dangerous move. However, there is a real risk that he underestimates the resolve of the Chinese not to lose face.

It’s not all doom and gloom

Despite these three issues, there are positives in the region. Emerging market equities appear relatively good value at a time when there are few bargains around the globe. On a 2018 prospective price/earnings basis, emerging market equities are trading at around 11.5x, compared to 17.3x for US equities.

Of course there are still reasons to be cautious about emerging markets, and in the short term things could get worse before they get better. However, the current turmoil in these high-growth markets could provide opportunities for long-term investors who can handle the ups and down.

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