By Laetitia Baldeschi, Head of Research and Strategy at CPR AM
2018 was a particularly trying year for emerging assets, and especially emerging equities. The steep rise in the US growth rate at the start of the year as a result of tax reforms enabled the gradual normalisation of the Fed’s monetary policy. The dollar appreciated, US long-term interest rates rose sharply (the 10-year interest rate reaching 3.23%) and there was a slow upwards drift in the price per barrel of oil until autumn of that year. 2018 also saw a ramp-up of the trade tensions initiated by President Trump and a greater slowdown in Chinese growth than forecast at the start of the year.
These global conditions had a particularly strong adverse effect on the emerging world, which is traditionally sensitive to financial conditions, international trade and Chinese demand.
However, unlike during previous wake-up calls, particularly in May 2013 with Bernanke’s “Taper Tantrum”, most countries’ macroeconomic positions are far less unbalanced and their central banks are relatively responsive, with a real commitment to meeting inflation targets. There are some exceptions, of course, led by Argentina and Turkey, whose central banks have failed to respond in time to rising inflation, which is rising particularly fast in both countries. As we enter 2019, monetary retightening is still moderate, except, perhaps, in Mexico, where the key interest rate of 8.25% is in line with the peaks seen at the end of 2008, although inflation has started to fall.
Overall, 2018 was therefore admittedly difficult for the emerging financial markets, but was reassuring in terms of the economic governance of these countries, and so there is still every reason for hope as 2019 begins.
A more positive global environment in 2019
The factors behind the lack of enthusiasm for emerging countries in 2018 should gradually fade out, or even be reversed, in 2019. US long-term interest rates have already fallen from their peak, notably due to the fall in Fed funds rate expectations for the year. The prospect of the Fed pausing interest rate hikes creates a kind of ceiling for these long-term interest rates. Likewise, the dollar, which appreciated for a large part of 2018, could start to lose ground in the next few weeks (see Décryptage CPRAM – Quelle direction pour le dollar en 2019 ? December 2018).
The exchange rate is still a difficult variable to predict, but the traditional arguments used to explain fluctuations in the dollar all point in the same direction. Oil prices could tick up again, for instance, after bottoming out at the end of December. This is in any case the clearly expressed wish of the Saudis, who need a price per barrel of oil of around $80 to meet the needs of their budget. The Fed’s expected hiatus, while the ECB still plans to raise interest rates for the first time by the end of the year, should also help to drive down the dollar. The difference in current account balances of course still argues for the dollar’s depreciation.
The latest news from the trade negotiations also seems to suggest that tensions will ease by the 2nd quarter of 2019, although the more structural problems rooted in China’s very development model and issues regarding intellectual property will continue to be subjects of debate. A final point, which in our view is key, is that Chinese growth will continue to slow, but the multi-faceted stimulus plan introduced by the authorities to prevent economic conditions from deteriorating should start to produce results in the 2nd quarter of 2019. In this gradually brightening environment, investors could regain their interest in the emerging world, which, when taken as a whole, offers comfortable macroeconomic fundamentals and leeway in terms of economic policy, and particularly fiscal policy in some countries, which should allow them to shore up domestic demand if necessary.
Chinese growth will continue to be a central factor in this positive scenario for emerging markets
Growth slowed throughout 2018 and the most recent economic indicators are extremely mixed, including a substantial weakening of the manufacturing sector at year-end.
The deleveraging policies of companies and local authorities had an impact on the real economy due to the fall in investment throughout the year. The authorities responded fairly quickly, starting from the summer, by easing monetary and some regulatory constraints, and reviving an expansionary fiscal policy. Most fiscal measures won’t come into force before the start of 2019, and so their impact on domestic demand has yet to be seen. Other measures, such as the possibility of further bond issues to finance investment projects, and particularly investment in infrastructure, will require the approval of the National People’s Congress, which will meet in March. The impact of this stimulus will therefore be measurable in Chinese statistics from the 2nd quarter of 2019, after the always complicated New Year period. The resumption of trade negotiations with the US, after a period of fairly strong tensions, is a positive factor. We believe that the concessions already granted by the Chinese government in the form of an increase in foreign investment quotas and increases in agricultural and energy imports from the US, are also signs of China’s good will, above all given the urgent need to restore confidence in China. The fluctuations in the Yuan in 2018 highlight the central role of the management of its exchange rate against the dollar in Chinese foreign policy, adding to doubts about the room left for market forces to influence changes in the Renminbi’s value.
Note that Xi Jinping gained a stronger hold on power at the 19th National Congress of the Communist Party and the National People’s Congress in March 2018, with the abolition of the presidential two term limit; this means greater control over the economy by the party. 2019 is also the 70th anniversary of the founding of the People’s Republic of China. The authorities will be keen not to compromise this with a major growth calamity. They will therefore do whatever is necessary to keep growth above 6%.
Some countries in the emerging world are particularly worth watching
It’s difficult not to mention Brazil as the year gets off to a start. The nationalist candidate’s victory in the presidential elections has recently ended a long period of uncertainty about the country’s leadership, after the labour party candidates’ setbacks. Investors gave him a warm welcome on the markets, moreover. That said, many fundamental issues will remain unresolved in Brazil. Firstly, Mr Bolsonaro is far from having a majority in both chambers. He will therefore be restricted in his actions. Secondly, the entire election campaign was built around the issue of security; Mr Bolsonaro is very much without a clear electoral mandate for reforming the country, especially for the infamous pension reform. A certain disenchantment is therefore likely after the euphoria of victory. He will, however, benefit from slightly better domestic economic conditions, with a central bank that has managed its inflation target relatively well. If our central scenario comes to pass, Chinese demand should pick up again and slightly boost Brazil’s growth.
The other big Latin American economy, Mexico, is also facing a major change in the country’s leadership. In this case though, the new President López Obrador has a majority in both chambers, which will give him considerable scope for action. On the other hand, his first announcements are not necessarily reassuring and could jeopardise the reforms introduced in recent years.
In Asia, India will return to centre stage in the emerging universe in 2019 when it holds general elections in the spring. Although until recently victory for Mr Modi party’s was all but certain, the loss of three states at the last local elections has reawakened concerns, with the possibility of an opposition being built. The other worry for the markets is Mr Modi’s clear challenging of the central bank’s independence, although it has managed the whole of the recent period quite successfully. This point is worth watching and the first decisions made by the new governor appointed by Mr Modi should be closely monitored.
More generally, Asia will continue to be very sensitive to trade tensions, due to its considerable openness to trade and highly integrated production processes. As a specific example, the sharp adjustment of electronic chip prices in the technology sector over the past few months will have repercussions for the most open economies, such as Taiwan and South Korea.
Closer to home, the growth outlook of Eastern European countries is worth paying attention to, as they are largely dependent on the industrial momentum in the eurozone, and Germany particularly. The importance of the automotive sector in Slovakia, Hungary and the Czech Republic will necessarily have macroeconomic consequences for these countries, in view of the major adjustments that the automotive industry will undergo in the months to come.
We will continue to avoid Turkey, South Africa and Russia, which are still very unstable countries whose macroeconomic imbalances and political circumstances are in our opinion reasons to be very cautious.
In conclusion, we believe that emerging countries are an attractive asset class as this new year gets under way, after it fell very much out of favour in 2018 even though there was no real deterioration in its fundamentals. Equity market valuations are below their historic average (price to earnings ratio of 10 rather than 12, versus 15 for developed countries). The earnings growth forecast for 2019 is still comfortable at 8%. In geographical terms, we prefer Asia to Latin America, with a positive bias towards China, before gradually returning to South Korea and Taiwan. In Latin America, Chile should benefit from the resumption of infrastructure investment in China. Mexico might also be a source of investment opportunities.