The performance of emerging market equities in 2018 was disappointing. It also made one thing perfectly clear: investors have differentiated among emerging markets. Those countries with the highest exposure to a strong US dollar over the last year, namely Argentina and Turkey, were disciplined by the capital markets. Countries that were better positioned mostly outperformed. 
The two main variables on which investor confidence and sentiment currently hinges are volatility and uncertainty. While we expect both to persist into 2019, we also hope for clarity on a number of issues. If these issues are resolved favourably – e.g. a stable or declining US dollar, a workable trade scenario, accelerating growth outside of the US – then emerging markets will likely benefit.
One area in which investors face the greatest uncertainties is trade. Donald Trump and president Xi Jinping have agreed to a trade truce at the G20 Summit, which delayed further US tariffs for 90 days. At the moment we believe that this truce, which is set to end on 1 March 2019, could be extended. Even the partial resolution – or stabilisation – of the trade war in 2019 could be a strong support for emerging markets equity performance going forward. However, should trade continue to be a major issue, as it easily could, long-term pressures are likely to be placed on markets.
At the World Economic Forum, China’s vice-president, Wang Qishan, acknowledged the risks facing major economies, including “unilateralism, protection and populism”. While China’s top officials have vowed to maintain “sustainable growth” as part of a deliberate, long-term effort to make the Chinese economy more balanced, questions are being asked about whether China can be relied upon to drive future growth in the emerging markets. The ability of Asia’s emerging markets to adapt to China’s changing economy, be it diversifying their trade partners or in some cases reinventing themselves, will be one to watch in 2019.
If US growth continues to be strong but Europe and China falter, then investors face the potential for slower growth in emerging markets and a rising US dollar. Outperformance will likely compel the Fed to raise interest rates at a quicker pace or higher than expected, thus attracting investors in search of higher yields. An economic contraction, on the other hand, will drive investors to seek safety – typically in US assets. If, however, other regions narrow the growth gap with the United States, or if global growth overall is sluggish but sustainable, then the US dollar will likely face downward pressure. The dollar’s strength this year will go a long way towards determining how risk assets fare.
Given the many variables and challenges, it can be easy to overlook the positives. The rising dollar in 2018, while a challenge for individual countries, did not result in contagion. Emerging market fundamentals remain relatively sound – country balance sheets have been stronger than expected, and fiscal deficits generally remain in good shape. Real interest rates are relatively high compared to developed markets. Interest rates were last at these levels in 2016, just before a two-year rally in emerging markets assets.
The growth premium between the emerging markets and developed markets narrowed in 2018 as the US economy outperformed, but we believe this premium will start to widen again in 2019. Looking forward, we expect US earnings growth will moderate and decline in 2019, potentially to a level below emerging markets.
Is it time to buy emerging markets again? Equity declines in 2018 have significantly lowered valuations. The emerging markets discount relative to US equities has widened beyond the 20-year average. At the end of the year, the MSCI Emerging Markets index was down to 11.8x trailing earnings, from 15.0x, a discount of about 35 per cent compared to the S&P 500 index.
In addition, this discount offers exposure to potentially greater growth opportunities – 8.0 per cent earnings per share growth versus 7.6 per cent for the US in 2019 – as well as relatively attractive free cash flow yields (6.5 per cent versus 4.8 per cent in developed markets and 4.3 per cent in the US). Emerging markets equities also offer opportunities to pick up dividends for yield-hungry investors – the emerging markets dividend yield is about 2.9 per cent compared to 2.1 per cent for the S&P 500 index.
Investors can hold emerging markets for tactical reasons, but we believe the emerging markets “story” – characterised by higher growth potential, stabilising institutions, a rising middle class of consumers – remains valid, regardless of higher volatility and relatively short-term changes in investor confidence. We believe that emerging markets companies with strong prospects, effective management, and relatively attractive prices remain one of the best ways to access this long-term investment opportunity.
James Donald is head of emerging markets at Lazard Asset Management. The views expressed above are his own and should not be taken as investment advice.