8th December 2015
One of the key headwinds facing emerging markets (EMs) has been the prospect of monetary policy normalisation in the US and uncertainty around the timing of the first rate hike has led to elevated market volatility. Heading into 2016 what has changed is the US dollar (USD) has strengthened 12% on a trade weighted basis over the past 12 months and all major currencies have weakened in comparison. So the ramifications of a tighter global liquidity backdrop look better priced into markets than a year ago.
The first rate hike, when it does transpire, will not resolve all concerns since decision making by the Federal Reserve (Fed) will remain data dependent. It should, however, subject to accompanying statements, serve to clear the air. We believe it is also likely to pave the way towards modest tightening with rates peaking at a lower level than in a more ‘normal’ cycle given sub-par US growth. Historically, the impact of rate hikes in the US on EMs has been mixed and ultimately dependent on the circumstances at the time; the past two tightening cycles led to net capital inflows into EMs.
Notwithstanding the above, ongoing divergent policy between the US and developed peers may well keep the USD supported and a strong dollar has tended to correlate with weak EMs performance relative to developed markets. So until investors have greater confidence that the USD has already done much of its strengthening, this headwind may have further to run.
Thus while a start to tightening in the US does not prevent EMs from performing in 2016, some stabilisation in the USD is likely necessary.
No major negative growth surprises
Developed world economic growth remains sub-trend but should benefit in 2016 from the ongoing lagged effect of a halving in energy prices. It should also be supported by further stimulus with the European Central Bank in particular looking to keep policy loose for longer. This in turn should be positive for EMs where economic growth surprises have been showing some signs of improvement after successive years of disappointment, although earnings have so far been slow to pick up.
In 2015, growth and policy concerns in China were key headwinds for EMs so any signs of improvement here should be a positive in 2016. We maintain our view that the likelihood of a hard landing in China is overstated. Clearly ‘old China’ industrial-led growth is under strain and a reluctance by the authorities to restructure some industries, given social and political pressures, has led reform progress to disappoint. However, this is only part of the story. ‘New China’ more consumer and technology orientated sectors are benefiting from strong structural growth and the economy is clearly moving away from a reliance on investment to drive growth. Indeed, growth in consumer spending looks set to outpace that of investment in 2015 for the first time in over a decade. Whether the property market continues to pick up in 2016 also bears close monitoring given property has a more direct impact on wealth and consumption than industrial activity.
Importantly, the Chinese authorities have the tools at their disposal to support the economy when necessary. Indeed, the authorities have recently implemented both monetary and fiscal stimulus with more likely to follow. While we expect growth to continue to decelerate over the longer term to a more sustainable level, the implementation of expansive policy should help stabilise growth in 2016.
Thus while hard landing concerns in China are unlikely to disappear, we expect them to ease over 2016 which should be a positive for EMs.
Single country challenges and opportunities
Aside from China, reform implementation is underway in several significant EM economies which could lift GDP. In India, for example, there is a strong political mandate for change and an opportunity for a step change to a higher growth rate over the long term; India has now overtaken China as the world’s fastest growing significant economy. However, elevated expectations are susceptible to disappointment and valuations are currently rich.
Meanwhile the outlook for Brazil remains challenging. The authorities are trying to undertake necessary fiscal reform, but against a backdrop of restrictive monetary policy and weak commodity markets. Should orthodox policy be maintained and balance sheets adjust, Brazilian growth should recover but in the immediate term political risk remains elevated.
There are a number of geopolitical risks around the world, including Syria and the related refugee situation in Europe, but should these events escalate they are likely to have more global than EM specific ramifications.
Thus country allocation remains key and should only increase in importance as steps towards monetary policy normalisation in the developed world result in lower correlations between EMs.
The degree of bearish sentiment towards EMs has been unrelenting with record outflows from dedicated EM equity managers and after three consecutive years of underperformance compared to developed markets, valuations across metrics looks attractive, especially on a relative basis. The MSCI Emerging Markets Index is currently trading on around 11.0x forward price-to-earnings which is around a 30% discount compared to the MSCI World Index.
On balance then, EMs head into 2016 facing some of the same challenges they faced at the beginning of 2015. However, importantly we are further along in the adjustment process and should headwinds dissipate, could provide a basis for recovery. So in our mind, providing tightening by the Fed is modest and the USD shows signs of stabilisation, investors can refocus on the strong fundamental case for investing in EMs.
Thus no hard landing in China, an ongoing recovery in developed world growth and reform implementation should help EMs earnings to pick up and given attractive valuations, EMs are well placed to perform much better in 2016.