28 Feb 2019
Richard Titherington
In brief
ALTHOUGH GLOBAL GROWTH MOMENTUM HAS SLOWED, EMERGING MARKET ECONOMIES AND MARKETS REMAIN FIRMLY IN MID CYCLE. When we consider the outlook for EM equities in 2019, we don’t worry about late-cycle constraints. Nor do we worry about valuations-after last year’s battering, valuations are quite attractive.
Instead, we focus on two issues: the outlook for the U.S. dollar and uncertainty around U.S.- China trade tensions (EXHIBIT 1). As we explore in the following pages, we are guardedly optimistic on both fronts. We think the U.S. dollar may weaken, and we expect that U.S.-China trade issues will be resolved, in part because China has a strong incentive to make it happen.
Key issues for 2019
EXHIBIT 1: MACRO, GROWTH AND VALUATION
Source: MSCI, Standard & Poor’s, J.P. Morgan Asset Management; data as of January 2019. EM growth alpha: Consensus Economics. Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. REER = real effective exchange rate. Ranges: last 20 years.
As the Fed signals more dovish policy, we anticipate a weaker USD in 2019
EXHIBIT 2: EMERGING MARKETS EQUITY RELATIVE PERFORMANCE VS. USD
Source: MSCI, Standard & Poor’s, J.P. Morgan Asset Management; data from January 1990 to January 31, 2019.
ACWI = All Country World Index. EMF= Emerging Markets Free Index. REER = real effective exchange rate. Past performance is not a reliable indicator of current and future results.
Many market participants, ourselves included, began 2018 thinking USD would continue to weaken. Instead, the green- back strengthened. A strong USD is almost invariably a negative for EM equities, because it either reflects the relative attractiveness of U.S. (vs. non-U.S.) assets or testifies to tighter monetary conditions. Both scenarios have a negative impact on the EM asset class. Now, however, as the Federal Reserve (Fed) signals more dovish policy-last month the Federal Open Market Committee (FOMC) said it will be “patient” in determining the path of rate hikes-we anticipate a weaker USD in 2019 (EXHIBIT 2).
No one knows how U.S.-China trade negotiations will play out. But it seems clear that China has a much stronger incentive to resolve trade tensions with the U.S., especially as capex, consumer confidence and retail spending have all suffered over the past year. In China’s negotiations with the U.S., we expect generally that Beijing will make concessions on “old economy” sectors, including opening up market access on autos and financial services; lowering import tariffs in autos, auto parts and consumer products; and increasing imports of oil, liquefied natural gas and agricultural products. At the same time, we anticipate Beijing will hold the line on “new economy” sectors including software and health care services. If the U.S. were to negotiate very aggressively on certain sensitive issues-intellectual property, for example-it could stymie the resolution of the U.S.-China trade dispute.
Odds are in favor of resolution, we think. We anticipate that China will do everything it can to resolve trade tensions with the U.S. If that happens, it will be positive for emerging market and Asia Pacific (EMAP) equities; if it doesn’t, we expect China will move decisively to stimulate its domestic economy.
China is also critical to growth alpha, a key driver of EMAP equity performance. That is, when EM economies outperform their developed market (DM) counterparts (as they did during the 2003-07 period), EMAP equities tend to outperform. As China has been a key source of that growth alpha, if the Chinese economy improves or stabilizes, it could give a boost to EMAP equities
At its current level, the aggregate five-year expected return is close to the previous peak
EXHIBIT 3: AGGREGATE EXPECTED RETURN FOR MSCI EMERGING MARKETS
Source: J.P. Morgan Asset Management; data as of January 2019. Forecast is not a reliable indicator of future performance
Although EM earnings were flat in local FX terms in 2018, investors are more concerned about earnings in USD or EUR, and a strengthening U.S. dollar last year especially hurt EM returns in USD terms. Short of a global recession-which we do not foresee over the near term-it’s difficult to see EM earnings performance getting much worse in 2019. Any year-over-year comparison will be supported by last year’s dismal results.
A valuation level of 1.5x price-to-book for EM equities (reached at the end of 2018), while not an all-time low, was a clearly attractive entry point. Investors began 2019 with much reduced expectations. Now, following the rally in January, the asset class, at 1.6x price-to-book, is closer to fair value than it had previously been. However, according to our internal valuation framework, which considers the key sources of equity returns (earnings growth, dividends and change in valuations and cur- rency) over the next five years, the aggregate expected return for the MSCI EM index nonetheless stands at 14% (EXHIBIT 3).
At that level, our signal is nearing the highs over the seven years since we formalized our research signals. This suggests robust EM equity returns going forward. (At the start of 2016, the aggregate expected return was 19% and equities subsequently rallied; at the end of January 2018, the aggregate was 9% and the market then corrected.) We believe long-term investors should consider taking advantage of current valuation levels, especially on further weakness, to add to their EM exposure.
In sum, we are reasonably optimistic about the prospects for EMAP equities at this mid-cycle juncture. Global growth momentum has slowed, and volatility could persist. But barring a dire outcome related to trade or the U.S. dollar—neither of which is our base case scenario-we see a favorable outlook for EMAP equities in the coming year.
Important information
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