Emerging Markets As An Impressionist Painting
Authored by Andrew Sheets, chief cross-asset strategist at Morgan Stanley
Beautiful from a distance, a bit messy up close. That seems like a fitting description of emerging market assets at the moment, where a good top-down story is colliding with challenging country-level issues. Those issues shouldn’t disrupt the asset class overall, but they should encourage a divergence in flows between the haves and have-nots. We think this applies to both EM equities and fixed income.
Let’s start with the more attractive, top-down picture. If one wanted to create an ideal scenario for EMs, it might sound something like this: Growth that picks up, both outright and relative to developed market economies. Major policy easing from China that proves effective. Inflation that remains modest despite said improvement in growth. EM real rates that are already higher, reducing the need to tighten further. A Federal Reserve that’s struck a dovish tone. A dollar that is set to decline on the back of overvaluation, slowing US growth and that dovish Fed. And given this backdrop, EM valuations would be reasonable.
That paragraph, broadly, is the 2019 Morgan Stanley forecast. Our economists see EM growth rising from 4.3%Y in 1Q to 5.0%Y by year-end. We see EM inflation remaining low. We see the Federal Reserve on hold for the rest of the year (market pricing suggests even longer), and forecast the dollar to weaken significantly. And EM valuations, while varied, look reasonable. Equity forward P/Es, at ~12x, are a little above their 10-year average. Credit spreads are modestly cheap to the 10-year average. EM FX valuations remain well below average.
We are not alone in seeing these dynamics. Speaking to asset allocators over the last six months, there’s quite a bit of focus on the idea that, after a long period of underperformance, it is EM’s time to shine. Inflows into the asset class have picked up, and in meetings I’ve heard EM equities repeatedly mentioned as a sector investors feel comfortable allocating towards.
That popularity poses a risk, especially as valuations re-normalise. Our EM strategists currently have 6.6% total return upside to their year-end target, less than we see for equities in Japan, but still more than the US and Europe. However, we see another, more serious risk. While the macro EM backdrop borders on ideal, the up-close country stories are anything but straightforward
Mexico and Brazil both have new administrations, with the latter yet to address pension reform. South Africa is dealing with serious infrastructure issues. India and Argentina are heading into elections. Russia faces geopolitical risk. Korea has been hit hard by weakness in technology hardware. China growth has been weak, while trade issues remain unresolved. And that’s only a partial list of challenges.
In some sense, the fact that EM countries are experiencing political or economic uncertainty is par for the course (especially as those same issues are at play in DM). But at a practical level, we see the following dynamic: Asset allocators will likely continue to push money towards EM equities and EM fixed income based on that top-down picture. The managers who receive those funds will then have to find ways to allocate them, given the country-level stories. The outcome: A larger ‘winner’s premium’ for any cleaner EM story.
China equities: Jonathan Garner, our head of EM and Asia equity strategy, remains overweight China stocks with 10% total return upside to his target for MSCI China. China stocks offer reasonable valuations, improving earnings revisions, incoming stimulus and a possible catalyst in greater clarity regarding trade talks. For managers trying to deploy funds, we think that this remains an appealing combination relative to other regions.
Local rates in Mexico and Indonesia: Both countries offer high real rates and both should see a moderating inflation profile, allowing their central banks to ease policy more than the market expects. Indonesia offers higher real yields with a more fairly valued currency, while Mexico offers lower real yields with a cheaper currency. James Lord, our head of EM fixed income strategy, sees opportunity in both.
EM hard currency debt: This was one of the ‘top trades’ of our 2019 outlook, and continues to screen well on a cross-asset basis. It is an asset class with a 5.9% yield and trailing 12-month volatility of 4.8%. Since 2010, rolling 12-month volatility has rarely exceeded 5.5%. That’s a compelling risk/reward profile, and one reason why we continue to like it from an asset allocation perspective, even if our EM strategists are more tactically balanced.
On a cross-asset basis, we think that both EM local and hard currency debt are better sources of ‘income’ than US high yield. Between EM fixed income and equities, we think that fixed income offers better risk/reward. And we think that record-low levels of DM rate and FX volatility are good hedges against EM exposure in one’s portfolio.
Emerging market assets are attractive from afar and messy up close. As in impressionist painting, we think that the broader view will ultimately win out.