The stage is set for a rally in emerging markets, according to Brewin Dolphin head of research Guy Foster – just not right now.
Despite being heavily tipped at the start of the year, emerging markets have been one of the worst performing sectors in 2018. The MSCI Emerging Markets index is down 6.88 per cent, compared with gains of 4.75 per cent from the MSCI World, due to a combination of trade wars – the introduction of tariffs on Chinese imports into the US – and dollar strength, significant because many emerging markets have large amounts of debt denominated in this currency.
Performance of indices in 2018
Source: FE Analytics
Foster (pictured) originally predicted the dollar would weaken in early to mid-2019, lifting this headwind for emerging markets
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“If you go back through previous cycles,” he said, “and look at what happens to the dollar when you have a big fiscal stimulus – we saw it from Reagan, we saw it from the dearly departed Bush Senior, we saw it from Bush Junior – in each of those instances, you had that secular trend of a declining dollar which coincided very neatly with a secular trend of outperforming emerging market assets.”
However, Foster said the problem is that despite US President Donald Trump’s $1.5trn tax cut and $300bn increase in spending, there are two external factors that are likely to prop up the dollar for the foreseeable future.
The first of these is the situation in Europe, where growth is nowhere near as strong as expected this year.
“Given you had the dollar rise by 10 per cent, you normally expect that to be a big boost to European exports,” said Foster.
“Actually, European exports have underperformed and the reason is that on a trade-weighted basis, the euro hasn’t really shifted all year. Part of that is our [the UK’s] fault, with Brexit.
“But the biggest part of it is obviously that China is a bigger share of this cycle of European exports than it has ever been before – and European imports, for that matter.
“And so the fact that the renminbi was so weak against the dollar and by implication against the euro as well meant that actually the two just kind of offset each other.”
Foster said that with growth in the eurozone weak and expected to stay this way for the foreseeable future, it has made investors go long dollar assets on a speculative basis.
As a contrarian investor, this would normally be the point at which he would be looking for this trade to peak and rollover. However, he said a second tailwind for the dollar – the fall in the price of oil, down 26.08 per cent from its peak this year – will support it for longer.
Performance of index since 2018 peak
Source: FE Analytics
“That fall in the oil price actually means that US inflation is going to go down faster than European inflation, that’s a function of two relative tax rates,” he explained.
“That means that real interest rates in the US, even if the Fed stops hiking, are likely to creep up relative to European rates. So that stronger dollar for another quarter or so is another source of pain for emerging market investors.”
Despite this continued headwind, Foster does not expect emerging markets in 2019 to see anything like a repeat of their poor showing in 2018.
He said investors’ lowest weighting to emerging market debt for five years makes this area in particular a good contrarian play and, referring back to the connection between fiscal stimulus and dollar weakness, said: “We would expect that to happen again, it’s just that there’s a growing risk that it happens really towards the end of next year rather than towards the beginning.
“Most likely is that emerging markets can maintain their relative valuations and then you have got everything set up for a meaningful rally.
“The difficulty is the timing.”
Foster is not the only asset allocator who is positive on emerging markets. Peter Toogood, chief investment officer at The Adviser Centre, recently said that while the sector has taken most of the pain in the last 12 months “and, in fact, for the past five years”, it is now undervalued in an historic context, with markets such as Brazil and Russia particularly compelling.
He added that emerging markets still represent the highest GDP growth opportunity and, more importantly, profitability is improving after five fallow years.
“While we fret about debt levels in the developed world, emerging countries still have positive real yields and relatively normal economic cycles,” Toogood continued.
“The heavily indebted, greying developed world will not set the tone for the next decade; rather, it is the emerging markets that will drive global growth. In other words, we flourish if the emerging world thrives, so let’s hope that globalisation has not been cancelled and that politics is just a little less angry in the future.”
David Lafferty, chief market strategist at Natixis Investment Managers, added: “For investors with a strong stomach, we favour emerging market stocks as the headwinds from Fed tightening and US dollar strength are likely to wane. In addition, the carnage in emerging market stocks already reflects our macro concerns for next year.”
However Jeremy Podger, manager of the Fidelity Global Special Situations fund, continues to be wary about the weakness of emerging market currencies compared with the US dollar.
“Whilst the worst of this weakness may now be behind us, the currency background remains a potential threat in 2019, particularly for those countries most reliant on commodity imports or external financing of current accounts,” he finished.