Emerging Markets - In Or Out?

It has been a challenging year for emerging markets, but it does not mean the opportunities are lost for long-term investors.

It has been a challenging year for emerging markets (EM) with the main index down around 10%.¹

Negative sentiment has been driven by the intensifying U.S./China trade war, higher U.S. interest rates, a stronger U.S. dollar and twin crises in Turkey and Argentina.

Equity markets have fallen in response. So is it time to remove your money from EM?

While periods of volatility are never comfortable, we believe it is important to look at events through a long-term lens.

From that perspective, we not only think that EM will weather the current storm but have the potential to deliver strong returns.

Why the sell-off?

The current upheaval in emerging markets is due to a number of factors - chief among them the threat of a trade war between the U.S. and China. This has seen each side impose a series of retaliatory tariffs on a variety of goods, culminating in U.S. President Trump slapping 10% tariffs on $200 billion of Chinese products at the end of September.

This has weighed on sentiment across emerging markets, notably Asia. The concern is that the standoff could escalate further, destabilizing the global trading order.

Whatever the reasons lower correlations between world markets is, in many ways, good news for international investors. For those seeking to reduce risk exposures, it provides a tailwind for the traditional benefits of geographic diversification to kick in without sacrificing the potential to generate returns.

How likely is that to occur?

Trade wars

While we can't rule anything out, we think the chances are remote.

First, the latest tariffs must be put into perspective. Despite all the bluster, the economic impact of these tariffs has thus far been fairly limited (the latest tariffs account for 0.1% of China's economic output).

Second, when viewing the negotiations we should take into account what the U.S. administration would deem a success in achieving its policy aims. The current approach reflects President Trump's key political goals: confronting China economically and strategically, while restoring jobs in domestic manufacturing.

Once he deems these to have been met, we may see a sea change in negotiations. After all, despite much sabre rattling, the U.S., Mexico and Canada agreed a revised version of NAFTA (known as USMCA) in relatively short order.

The final terms also closely resemble those of its predecessor. We wouldn't be surprised to see a similar 'victory' in the China/U.S. trade spat - a victory Trump may be keen to secure in light of the Republican's disappointing showing in the U.S. mid-term elections.

Away from tariffs, officials in Beijing have demonstrated their willingness to support the country's economy, including recently injecting $22 billion into the financial system via its medium-term lending facility.

This followed the official removal of a foreign-shareholding cap in domestic banks and asset managers. We would expect this type of support from policymakers to continue, if and when it is needed.

Given China's importance in the global economy, this will help bring stability to EM, notably in Asia.

Not about EM

Perhaps more important is the strength of the U.S. dollar, driven by U.S. Federal Reserve (Fed) interest rate rises and the anticipation of further monetary tightening. This has adversely affected countries with large dollar-denominated debts, notably Turkey and Argentina.

Looking more closely at Turkey, its government and corporate sectors have made the mistake of gradually accumulating large dollar-denominated debts, while relying on income in Turkish lira to repay these foreign currency liabilities.

The precipitous fall in the lira, compounded by the country's stubbornly loose monetary policy over much of the year, has now made dollar debts considerably harder to repay.

It has also rendered lenders more reluctant to provide new loans given pronounced concerns about worsening asset quality. The political climate in Turkey also destabilised markets, notably around the independence of the country's central bank.

In our view, Turkey and Argentina are more outliers than portents of what's to come. After all, only Turkey is currently included in the MSCI EM Index and accounts for less than 1% of the index. Any fallout should therefore be minimal.

Of course, as we saw in the Asian crisis of the 1990s, there is always the potential for contagion.

Today, though, most EM economies are in better shape than they were during the Asian crisis of the 1990s. Debt levels are relatively low as a proportion of GDP, and have longer maturities with emerging market central banks now holding a much larger stock of dollars in their reserves.

A much greater proportion of debt is also now issued in local currencies, so the risk of currency mismatch is smaller. Fiscal and monetary policy institutions have improved, and debt markets have matured and deepened.

Finally, during the Asian crisis, many countries had large current-account deficits, draining foreign currency reserves. This time most countries have much smaller imbalances.

Compelling range of choices

While EM performance may have suffered, there remains a multitude of attractive opportunities for active equity investors. Over the last decade, improved economic conditions have resulted in a marked expansion of the EM equity universe; there are now over four times as many emerging market companies spread all around the world in which to invest than there were in 2003.

Numerous corporations in EM are already out-competing their developed-world rivals in more markets across highly sophisticated sectors, such as electrification, automation, artificial intelligence and machine learning.

In addition, EM valuations are now well below their historic average discount to developed markets.

As such, the recent volatility is creating compelling opportunities to invest in the high-quality businesses that have the potential to outperform over the long term.

So, while recent EM upheaval is unwelcome, the asset class still offers a compelling opportunity for investors willing to take a long-term approach.

¹ Source: MSCI Emerging Market Index 1/01/2018 to 11/13/2018

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Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund's investment return and principal value will fluctuate so that an investor's shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund's portfolio. There is no assurance that the Fund will achieve its investment objective. Past performance does not guarantee future results.

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

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