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The outlook for trade relations and US policy rates continues to dominate the prospects for emerging market (EM) equities. However, even as there is some relief on both fronts, EMs are unlikely to reclaim their January 2018 peak.
The first half of this year delivered strong returns for global markets, the number of policy conflicts and heightened uncertainty notwithstanding. EM equities delivered a strong 10.7% return in USD terms during the first six months of the year, but were outshone by developed markets (DM), which gained 17.4% over the same period. Vacillating views on the outlook for US monetary policy and for global trade have driven several rallies and sell-off episodes to date and remain critical for the second half of the year.
On the trade front, there has been some de-escalation at the G20 summit in Osaka in early July, with an agreement to restart Sino-US negotiations at an undefined date. While no “grand bargain” was struck, it was not a complete breakdown in relations either. It implies that the tariffs already in place will be maintained, whereas the threatened additional tariffs will be delayed. In addition, the US has agreed to temporarily relax its restrictions on US sales to Huawei and eased pressure on China to change its intellectual property legislation. In return, China agreed to import a greater amount of US agricultural products.
This outcome has had two effects. For one, it reignited market risk appetite, allowing the S&P500 to surpass its previous April peak. At the same time, it prompted expectations for Fed rate easing to recede somewhat and the US dollar to strengthen slightly. Yet, markets remain nevertheless fully convinced that the Fed will deliver an “insurance cut” in the near term, pricing in a 75% probability of a rate cut at the July meeting and a 62% chance of two cuts by September. However, chances for additional monetary easing in 2019 or 2020 are seen at less than 40%.
Will the effective easing of financial conditions allow EM equities to recover just as the earlier tightening depressed them? Only at the margin. The asset price response has not been vigorous so far and economic activity readings have been disappointing in a large number of key countries in Q1 (Brazil, Russia, Mexico, South Africa and India). The lacklustre global manufacturing cycle, to which EM growth is closely tied and which is driven by China’s secular slowdown, adds additional weight.
What is more, trade concerns continue to linger even after the G20 meeting, depressing consumer and business confidence and derailing investment plans. This extends beyond China, which itself sits at the heart of a global web of value-added chains. The US administration is also at odds with Europe and Japan over car imports, with Vietnam over apparel and with India over a number of products. Finally, there is a series of country-specific issues, often political in nature, that also put domestic constraints on a revival of EM growth.
In the two years between January 2016 and January 2018, the MSCI EM rallied by 92% in USD terms (net total return). This took place against the backdrop of four Fed rates hikes (out of a total nine in this cycle) and closely tracked the rise of the S&P500 (see Chart 1). However, the relationship between emerging and US markets came apart thereafter, as the S&P500 went on to reach new heights, while the MSCI EM began to sell-off, and remains some 14% off this peak despite a recovery this year. This second phase took place against the backdrop of an additional four rate hikes. The divergence is perhaps suggestive of the notion that during the first phase of tightening the global economy was thought to be in full swing, whereas this was less so during the latter phase, when trade tensions intensified. It also suggests that investors believe that the trade conflict will ultimately benefit the US economy (“winning the war”), to the detriment of the rest of the world.
We do not subscribe to the latter view, but trade frictions are nevertheless likely to continue to weigh on EMs. Because the trade conflict is also increasingly becoming a “tech conflict” we downgrade Taiwan from overweight to neutral. The slowing US and Chinese economies further constrain the outlook, even if policy stimulus seeks to counteract the downswing. As a result, we make few other changes to our allocation. A key change in view is Brazil, where the pension reform has moved along more swiftly and with greater support than expected as the Bolsonaro administration has effectively transferred the project to Congress. While residual risk remains, we upgrade Brazil to neutral for now. We upgrade Romania to overweight on attractive valuations and strong activity, while downgrading Saudi Arabia to underweight on the back of oil production cuts.
*The publication reflects asset performance up to 28 June, 2019, and macro events and data releases up to 5 July, 2019, unless indicated otherwise.
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