Blog: Paradoxical reasons to be positive about EM



Devan Kaloo
Devan Kaloo

Devan Kaloo is head of global emerging market equities at Aberdeen Asset Management

 

Investors may feel a strong sense of déjà vu when contemplating the issues confronting emerging market equities today. Three areas have been a source of recurring anxiety in recent years: China, monetary policy in the West, and the state of domestic corporate earnings. However, on each of these topics we find reasons to be optimistic about the outlook for emerging markets. Indeed, if you delve beneath the surface it’s possible to find signs of encouragement.

China

There is no doubt China’s economy is slowing. Official gross domestic product (GDP) figures show it but it is also reflected in softening manufacturing activity as well as of course the response from authorities to this “new normal”. Beijing has acted to loosen monetary policy repeatedly over recent months, relaxed rules on residential house purchases to support the property sector, enacted “supply-side” reforms in the state-owned enterprise sector, and, contrary to prior expectations, allowed some depreciation of the Renminbi against the US dollar.

But China is not all doom and gloom. There is an abundance of jobs being created and the economy is undergoing an important transition from one based on investment to one based on consumption. Retail sales are holding up well and so too is the savings rate which should help consumers to keep spending. This resilience is overlooked, with critics pointing to the slowdown in manufacturing as a sign that China is in trouble. Yet services now account for a bigger proportion of the economy than manufacturing and the Chinese consumer is a real boon for the economy.

There are, of course, imbalances in the Chinese economy, but the authorities are not blind to them. They are sensitive to the consequences of an economic slowdown and are looking to support the economy through a challenging transition. This is important because stability in China is important to sentiment across emerging markets, not least the commodity exporters.

Monetary Policy

Expectations for monetary normalisation in the US triggered a multi-year dollar rally that created havoc for most emerging market currencies as well as domestic interest rate policy. Currencies devalued creating a spike in imported inflation; this had to be countered by significant upward adjustment of local interest rates. The impact on emerging market economies and stock market returns was significant – but a necessary evil. Emerging market current account deficits had widened to unsustainable levels and needed to balance; local currencies were arguably overvalued in the context of persistent inflation.

Where we stand today is after a period of necessary structural adjustment. Trade balances have turned and continue to adjust for the better. Looking at the current account balances now, most have moved back into positive territory. Inflation is easing and interest rates are being relaxed across much of emerging markets. The US dollar rally seems to have taken a pause, which is supportive of currencies too.

But the reality is that the economies of North America and Europe, the two major export destinations for emerging market trade continue to struggle. Economic indicators suggest the US economy could actually be slowing down again. While this presents a significant obstacle to an export-led recovery of our emerging economies, one very positive take away is that developed market monetary policy is expected to remain extremely loose for some time to come. In our view this could be supportive of local currencies as well as give central banks more flexibility to lower interest rates to stimulate domestic demand. Assuming we see no significant near-term resurgence of growth in the US or Europe, the backdrop should remain reasonably benign for risk assets such as emerging market equities, where economic fundamentals look reasonable after the adjustment of recent years.

There are, of course, imbalances in the Chinese economy, but the authorities are not blind to them. They are sensitive to the consequences of an economic slowdown and are looking to support the economy through a challenging transition. This is important because stability in China is important to sentiment across emerging markets, not least the commodity exporters.

Monetary Policy

Expectations for monetary normalisation in the US triggered a multi-year dollar rally that created havoc for most emerging market currencies as well as domestic interest rate policy. Currencies devalued creating a spike in imported inflation; this had to be countered by significant upward adjustment of local interest rates. The impact on emerging market economies and stock market returns was significant – but a necessary evil. Emerging market current account deficits had widened to unsustainable levels and needed to balance; local currencies were arguably overvalued in the context of persistent inflation.

Where we stand today is after a period of necessary structural adjustment. Trade balances have turned and continue to adjust for the better. Looking at the current account balances now, most have moved back into positive territory. Inflation is easing and interest rates are being relaxed across much of emerging markets. The US dollar rally seems to have taken a pause, which is supportive of currencies too.

But the reality is that the economies of North America and Europe, the two major export destinations for emerging market trade continue to struggle. Economic indicators suggest the US economy could actually be slowing down again. While this presents a significant obstacle to an export-led recovery of our emerging economies, one very positive take away is that developed market monetary policy is expected to remain extremely loose for some time to come. In our view this could be supportive of local currencies as well as give central banks more flexibility to lower interest rates to stimulate domestic demand. Assuming we see no significant near-term resurgence of growth in the US or Europe, the backdrop should remain reasonably benign for risk assets such as emerging market equities, where economic fundamentals look reasonable after the adjustment of recent years.

It would be naïve to downplay the severity of the headwinds facing emerging markets. Yet, it’s equally detrimental to get caught up in the negativity and miss the broader, more balanced, picture. Yes, there are various problems in China, but the country has various strengths in its favour too, such as a very high savings rate and low levels of household debt.. Monetary policy may have weighed down on emerging market currencies but this has encouraged much needed adjustments in the trade accounts of many emerging countries. And finally, earnings are far more encouraging than they seem at first glance.

As veteran emerging market investors, we’ve been here many times before and take comfort in doing our extensive country and company first-hand research. But perhaps most importantly of all, we’ve learnt not to lose sight of the need for having a long-term view.

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