The general expectation for emerging markets in 2019 is renewed outperformance.
As Goldman Sachs Asset Management notes, 2018 saw a substantial drawdown in emerging market assets, against expectations. Goldman attributes this underperformance to lower-than-expected growth in emerging economies.
Mercer also notes that 2018 was “very challenging” for emerging market economies, as a number of them were hit by currency crises — Turkey, Argentina and, to a more limited extent, Brazil and South Africa. Meanwhile, China has been involved in an escalating trade dispute with the United States.
Morgan Stanley’s economists also explain in their 2019 Global Macro Outlook that rising U.S. rates, a strengthening dollar and lingering trade tensions left emerging markets nearly defenseless in 2018. Even so, most of these countries maintained fiscal discipline, setting them up for solid growth as the headwinds subside, according to Morgan Stanley.
This may be why — despite the negative market sentiment toward emerging markets during 2018 — several industry leaders remain cautiously optimistic about both EM equities and EM debt.
One reason for this optimism is that many emerging market economies are still in the early stages of longer-term expansions.
“We are of the view that, broadly speaking, the emerging world is at the earlier stages of the business cycle, whereas a number of developed economies (particularly the U.S.) are now at the later stages,” Mercer explained.
In addition, emerging market debt and equities both seem attractively valued.
Goldman, in particular, sees attractive return potential for EM assets in 2019, particularly in currencies and equities, which it expects to be unleashed by improving growth.
Based on Goldman’s estimates of fair value, EM currencies are undervalued by 12% and 23%, when aggregated using the MSCI EM and GBI indexes, respectively.
“The magnitude of this undervaluation is similar to what we observed in early 2016 and the early 2000s; both periods were followed by good returns for EM currencies,” Goldman explained.
In addition, EM equities are trading at an “attractive” 25% discount to developed market equities, while also offering potentially higher expected earnings growth, according to Goldman.
In light of the extreme valuation differences between U.S. and emerging-markets equities, Morgan Stanley strategists have issued a double upgrade for emerging markets, moving from underweight to overweight. Their base-case forecast calls for an 8% price return for the MSCI EM index in 2019.
“A slowdown in U.S. growth with EM reaccelerating means EM earnings growth should exceed that of the U.S. in 2019 after lagging in 2018,” according to Morgan Stanley.
EM Local Currency Debt
Looking specifically at EM debt, industry leaders see local currency debt as one of the most attractive of main growth fixed income assets over the coming year.
Morgan Stanley’s emerging market debt team changed its stance on local markets to bullish, thanks to improving GDP growth relative to developed markets, coupled with the weakening dollar.
According to James Lord, head of the emerging market fixed income strategy at Morgan Stanley, “emerging market assets are cheap and a rebalancing in global capital flows should lead to local currency strength.”
Moreover, relative to corporate and securitized debt, emerging market hard currency sovereign debt recently reached its widest spread since the financial crisis, according to Morgan Stanley.
Mercer also sees growth potential within the sector.
According to Mercer, the asset class looks favorable because the yield is attractive and the currencies that were oversold are perhaps due a rebound.
Mercer also notes that the inflation outlook is reasonably positive for emerging market bonds, “as economies are likely to grow without facing significant capacity constraints and labor markets have plenty of room to tighten without causing wage growth pressures.”
The Challenge of China
Looking specifically at China, which Mercer calls “the powerhouse of the emerging world, the outlook is highly uncertain.
According to Mercer, the outlook for the Chinese economy is dependent on whether trade tensions stabilize, deteriorate or improve.
“While we believe eventually a deal will be reached that will lower or eliminate the tariffs applied by the U.S. in 2018, we do not have a strong view on whether this will be late in 2018, in 2019 or beyond,” Mercer states.
Meanwhile, Goldman thinks that the biggest risk to its view in both 2019 and over the medium to long term is China.
“In the near term, we see broad-based policy support as a sign that policymakers are dissatisfied with current economic performance,” Goldman states. “We therefore expect support to continue until the growth environment improves.”
Nonetheless, Goldman’s 2019 forecast for 6.2% growth would mark the slowest pace of Chinese growth since the early 1990s.
Mercer also notes that China has been slowing, largely because the government has been striving to contain the shadow banking sector and ease financial imbalances.