Potential Catalysts
Though timing on these is very difficult to predict, we see several potential catalysts that could help turn around EM:
Trade dispute resolution. Based on how much China and the United States have to lose from a full-blown trade war, we continue to expect a compromise that results in little, if any, negative impact on the two economies. Although a resolution to the dispute may not come until after the midterm elections, we see a trade deal with China as likely and a potential positive catalyst for EM.
U.S. dollar reversal. Even though EM countries are not as U.S. dollar sensitive as they were a decade or two ago, dollar strength is a problem for financially weaker countries, such as Turkey. The greenback may soon run into resistance given U.S. trade imbalances and indebtedness, while a trade deal is a potentially bearish catalyst.
Earnings stability. Aggregate earnings estimates for EM have fallen by about 4 percent over the past three months, while earnings estimates for the S&P 500 have risen by 3 percent during that time (based on FactSet consensus estimates for the next 12 months). We expect the still solid EM economic growth outlook to help support the EM earnings outlook. Stimulus injections into some of the weaker economies to boost growth and support currencies (including China) should help as well, in addition to the potential for trade dispute resolution and U.S. dollar reversal.
Conclusion
EM could be an intriguing contrarian idea given that the bearish sentiment appears to be approaching extreme levels. Though the fundamental picture has dimmed a bit in recent months amid challenges facing the financially weaker countries, we believe most of the fears surrounding EM will pass fairly soon. We do not see many more dominoes left to fall in this EM crisis episode. For suitable investors who do not own EM stocks, or who are aggressive contrarians, the group may be looking increasingly buyable here.
We’re looking for positive catalysts to emerge in the coming months, suggesting the potential for a pivot in EM performance in the near term. We do not expect much spillover into the U.S. economy and markets. We especially are encouraged by the stability in U.S. credit markets in recent months. Comparisons with the period of EM weakness the mid-1990s are instructive and suggest that it may be possible for U.S. stocks to hold their own amid overseas weakness. That said, a pullback and volatility before midterm elections is normal and quite possible.
John Lynch is chief investment strategist for LPL Financial.