Emerging markets endured a challenging 2018, largely – though not exclusively – due to factors originating beyond their own shores. 
The US was the prime culprit, with an unholy trinity of a stronger dollar, higher government bond yields, and a general protectionist stance driving investors out of emerging market assets over the summer. Concerns around specific ‘problem children’ like Argentina, Venezuela and Turkey added fuel to the fire, while higher energy prices throughout much of the year penalised the currencies of oil importers such as India.
Emerging markets were relatively robust during wider market turbulence in February 2018, but we do not believe they are likely to prove exceptionally resilient in any substantial future downturns. Weakness from April 2018 onwards (as markets priced in a less accommodating US central bank and ongoing trade concerns) highlighted that emerging markets are still markedly vulnerable to external factors. This sensitivity affects how investors view emerging markets, and makes a ‘bottom-up’ approach far more challenging for emerging market investment. But while some generalisations are possible, investors must remember that emerging markets are not an homogenous group, but very different markets with very different dynamics.
Some of these dynamics can be drawn along geographical lines. Asian E emerging markets, for example, enacted significant and far reaching reforms following the brutal financial crisis which hit the region in the 1990s. This meant a ‘de-pegging’ of currencies against the US dollar, widespread austerity, a clean-up in balance sheets, and heightened awareness of minority equity shareholders. Collectively, these reforms have created an environment in which well-managed companies can do well, and have seen Asia increase as a proportion of emerging market indices. By extension, the technology sector (highly prevalent in Asian emerging markets), has also risen in index prominence.
Central and Latin America, on the other hand, failed to implement widespread reforms like these. Many emerging markets in this region simply rode the commodities boom of the 2000s, leaving them at the mercy of commodity market fortunes today.
These countries also carry additional risks, which would quickly become apparent in a downturn. Brazil, for example, is in some ways an economy in recovery, but this is fragile (with volatile currency and equity markets) and a great number of factors could easily knock it off course. Brazil is also usually perceived as very resource exposed – the fact that this is not entirely accurate is meaningless. When it comes to emerging markets, perceptions can be everything, and in times of market stress these economies can be penalised for flaws both perceived and actual.
Beyond Asia and Latin America, the rest of the world is a mixed bag for emerging markets. Russia has come further than investors generally acknowledge, in terms of reforms and shareholder awareness. However, the Russian marketplace remains very energy exposed and vulnerable to wildcard events like sanctions and geopolitical crises.
Meanwhile, eastern European emerging markets, such as Poland, the Czech Republic and Hungary, are effectively derivatives of the eurozone, largely doing well when Germany does well, rather than performing on their own credentials.
As a caveat, we note that even within geographic groupings, economic fundamentals and investable appeal can vary between emerging markets. Investors should expect differences in behaviour between emerging markets ahead, particularly when global markets are very volatile. Even so, developing economies are fundamentally more robust today than in previous global downturns (barring one or two exceptions). The current environment is a world away from historical crisis points, with aggregate current account positions, foreign exchange reserves and overseas bank claims in markedly better shape. A clearer election calendar in 2019 (following a high-octane period where political cycles had lined up across a number of emerging markets) should also provide welcome relief.
As we enter into 2019, significant focus remains on the relationships between the US and emerging markets, particularly those in Asia. But while trade disputes between the US and China dragged down all Asian emerging markets in 2018, they also added fresh impetus to inter-Asian trading relationships. Asian emerging markets are beginning to respond to 2018’s challenges with more locally focused solutions, such as new potential trade deals currently under discussion. Lowering tariffs and barriers to trade within the region would be good news for cross-border supply chains in the technology sector, allowing greater flexibility for emerging market exporters and developed world buyers, and would be positive for growth both locally and globally.
Investors should keep an eye out for convincing and pragmatic emerging market policies, although for emerging markets to truly rebound overall, we must witness a sustained easing of trade tensions. Nonetheless, the investment market decline experienced by emerging markets this year is far worse than any decline in their economic activity, meaning that market valuations are broadly cheaper going into 2019 than they were at the start of 2018. Taken altogether, we believe that selective emerging market exposure continues to offer attractive long-term investment potential.
Jaisal Pastakia is investment manager at Heartwood Investment Management. The views expressed above are his own and should not be taken as investment advice.