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Time to overweight emerging markets?

2 October 2018

Are valuations now justifying tactical overweight in emerging market equities? Richard Larner, head of Research at Brooks Macdonald looks at the fundamentals.

The recent emerging market sell-off was driven by a confluence of headwinds, including tighter global financial conditions and an appreciation of US dollar, concerns over slowing global growth and growth in China, in particular, and the threat of increasing trade protectionism. These factors even drove mini liquidity crises in certain countries considered vulnerable to external shocks, such as Turkey and Argentina. Investors now appear to be pricing contagion from Turkey and Argentina into the asset markets less vulnerable emerging countries, such as India (as indicated by recent foreign exchange market movements). We note that the broad decline in sentiment towards the region has pushed valuations to attractive levels (See figure 1 below).

While the market may be pessimistic, we do not believe there will necessarily be contagion outside of Turkish and Argentinian assets, given the current level of US dollar liquidity, prevailing foreign exchange rates and the fact that the majority of the emerging market countries have sufficient foreign exchange reserves to service their debt burdens, at least in the near term. However, the short term path of emerging market equities appears highly dependent on the relative strength of the US dollar and the outlook for the world’s reserve currency is far from certain.

There are good reasons to hold a negative outlook on the dollar; US Government spending is increasing, the US’s budget and trade deficits are widening and inflation is beginning to rise. Equally there are good reasons to be positive; the Federal Reserve one of the few major central banks to be tightening policy, oil prices are rising, US tax reform is causing the repatriation of US dollars held offshore, and political uncertainty in Italy may lead the risk backdrop to deteriorate.

What is interesting is that many of the positive themes have played out in recent months, yet the dollar has not appreciated. This suggests that its rally may be fading, with many positive developments priced in and investors now starting to concern themselves with the size of the budget deficit.

This deficit is likely to expand regardless of the outcome of the mid-term elections, with Republicans expected to propose more tax cuts and Democrats expected to propose spending increases.

Nevertheless, timing any shift in dollar sentiment will be difficult, given that dollar liquidity woes appear ongoing, which may support the currency’s attraction as a safe-haven. Meanwhile, the European Central Bank and Bank of Japan do not appear to be rushing to raise rates. As a result, we expect the dollar to be range bound in the near term, but for the US’s large budget deficit to begin to drive dollar weakness over the longer term.

Given this, we believe concerns over emerging market funding pressures may lessen and the region’s recent underperformance (See figure 2 below) may therefore offer a buying opportunity. This is particularly the case given the potential for China’s government to boost sentiment towards the region by announcing the implementation of fiscal stimulus, as it has done in recent years.

As a result, we have opportunistically moved our emerging market exposure to a small tactical overweight in higher-risk portfolios. If we gain greater clarity in the near-term path of the dollar, we will revisit both the size of this position and the risk profiles in which we incorporate it. As such, we will be monitoring some of the key drivers of the dollar closely in the coming months, including political events, the strength of US inflation and direction of US monetary policy, and changes in global growth momentum.

Professional Paraplanner