Time of transition for Emerging equities on the back of the Trade War?

It is likely that 2018 and 2019 will come to be seen as transition years for emerging markets. While they entered 2018 positively, continuing a long period of strength, stock prices declined substantially over the year. However, 2019 could mark the start of a new modest upward trend, underpinned by still-positive (relative) earnings growth and a reduced impact of the negative 2018 drivers.

2018: tariffs and interest rates take their toll

A promising start to 2018 faded fast as the US Federal Reserve started to tighten its monetary stance and the US administration’s corporate tax cuts prompted many US companies to repatriate overseas earnings. The result was a shortage of dollars in the global system, which typically has a negative impact on emerging markets.

Then came the announcement by President Trump of trade tariffs, followed by the threat of further tariffs, notably targeting China.

Even aside from the trade war risk, concerns also surfaced about the underlying Chinese economy, which has been growing at a slower pace as the Chinese authorities restrict credit in order to keep the economy from overheating. Meanwhile, infrastructure investments, a major contributor to the economy in the post-financial crisis era, fell off a cliff.

2019: bottom-up investing the way to go

There is reason to believe that the US and China may negotiate an economic ceasefire. President Trump has a record of talking tough and then softening his stance and negotiating. The pact that replaced NAFTA is a case in point. If agreement can be found, emerging market stocks will react positively.

The deal agreed during the G20 in early December is a short term relief of only 3 months. In the meantime if clear signs of economic weakness should occur, Beijing will likely provide significant stimulus.

It has already instituted export rebates, tax cuts for companies and households, lower reserve requirements for banks and new infrastructure projects. Banks have been ordered to lend more to the private sector, which represents 60% of the economy. Beijing could also weaken its currency to make its exports more competitive.

With this year as a guide, 2019 will certainly not be easy, going forward. 2018 was marked by enormous volatility. India, for example, was a standout performer until its financial sector hit the buffers in the third quarter. Shares in Brazil, on the other hand, soared after the election of Jair Bolsonaro in October. Mexico’s stock exchange was steady until the new government halted the building of a new airport and capped fees in the banking sector. Shares in Mexico’s largest bank have fallen 40% since October.

So, with many well-managed companies offering value, the bottom-up approach is the wisest approach to emerging markets. Although markets hammered growth companies in 2018, we think many investors will start to rotate back into those quality growth stocks in 2019.

Low short-term visibility, but a strong longer-term outlook

Visibility in emerging markets is poor and negative surprises are possible – notably further interest rate rises by the Fed and an escalation of the trade war.

On the other hand, after a substantial correction, valuations are attractive and any positive surprise should cause prices to surge. In addition, the potential for growth continues to be higher than for developed markets, where risks appear to be declining.

We recommend you to see 2019 as an opportunity to buy into an oversold market and hold your nerve to take advantage of the strong long-term fundamentals.