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Emerging Markets: Valuation Attractive but Trade Tensions Are a Risk

12/06/2018 12:00 pm EST

Focus: GLOBAL

Lindsey Bell

CFRA Investment Strategist, CFRA, Equity and Fund Research

Since bottoming at the end of October, the MSCI Emerging Market Index (MXEA) and MSCI Asia Ex-Japan Index (MXASJ) have advanced 8.5% and 9.9%, respectively (through Dec. 4). By comparison, the S&P 500 (SPX) has advanced 2.6% from its Nov. 23 low, writes Lindsey Bell Thursday.

While both emerging market indices are still lower year-to-date by double digits, and timing the market is never advised, it does lead one to wonder if the bottom has been put in and the recent run can continue. Valuation, growth prospects and stimulus certainly suggest there is the possibility for the group to continue to prosper. 

China is a key contributor of both the MSCI Emerging Market Index and the MSCI Asia Ex-Japan Index, accounting for 30% and 35% of the market caps of each. In 2018, these indices fell quickly out of favor as the U.S. dollar (USD) began to strengthen following its steady decline in 2017.

Rising interest rates in the U.S. also added pressure to emerging markets saddled with significant amounts of dollar-denominated debt. Finally, as trade tensions between the U.S. and China intensified, emerging market indices collapsed to bear and near-bear market territory (a decline of 20% or more). The Shanghai index was most significantly impacted, declining 24.8% through its October 18 low.

President Trump’s 25% tariffs on $50 billion worth of Chinese goods went into effect in July ($34 billion) and August ($16 billion), with China retaliating with $50 billion of tariffs on U.S. goods with the same effective dates.

The trade situation escalated in September when 10% tariffs were levied on $200 billion worth of Chinese goods. The two markets diverged, with the S&P 500 soaring to a new all-time high just before the second round of tariffs went into effect on September 24.

China, on the other hand, witnessed a steady decline it its stock market and an acceleration in the deterioration of economic activity. China’s economy was set to slow in 2018 given its focus on reducing debt, but trade actions expedited the slowdown. In the third quarter, China’s GDP slipped to 6.5%, its lowest level since 2009. Manufacturing data slowed to a level just above expansionary and fixed asset investments, a key indicator of GDP, have also slowed to levels not seen since 2000. 

In response, China sought to support the economy and offset the tariff induced slowdown with reductions in the reserve requirements for banks, a stimulus package (in July) and currency devaluations. Additionally, the government has backed off its efforts to reduce debt.

As the world’s largest exporter, China has used currency as a key tool to control prices in periods of significant dollar strength. Moves in the yuan (CNY) have been met with significant market volatility in the past. This year has been different, with the U.S. markets barely budging as the yuan approached 6.95. The Shanghai index moved lower but not in the knee-jerk manner it did in reaction to devaluations in 2015 and 2016. Indicating a more orderly devaluation process. 

For manufacturing, the currency devaluations were a boon in 2015 and 2016, but the move this year has not had the same effect on the manufacturing economy. PMI data from China slipped to 50.2 in October, the lowest level since July 2016. With a more favorable valuation of the yuan driving less upside than in the past, further moves to devalue the currency may be less likely. Additionally, the trade truce between Presidents Trump and Xi has led to the strengthening of China’s currency (chart below).

chart 1

The strong dollar has been trouble for other emerging markets, like Turkey, Brazil and South Korea, who carry large amounts of dollar-denominated debt.

In total, $3.7 trillion of dollar-denominated debt is outstanding in emerging market economies, the highest level on record. This issue is compounded by rising interest rates, courtesy of the Federal Reserve, which increases the amount owed by the borrowing entity. Notably, not all emerging markets are as highly levered. Indonesia, Nigeria and South Africa have grown dollar-debt levels less quickly and debt-to-GDP is less of a concern. 

Currently, Action Economics expects the dollar to remain stable near current levels throughout 2019. CFRA believes it is possible that the dollar could be pressured as growth domestically slows from the fiscal-stimulus-driven growth of 2018.

In the U.S., GDP growth is expected to slow to 2.5% in 2019 from 2.9% in 2018, according to the International Monetary Fund (IMF). Despite this, emerging market growth is still expected to significantly exceed advanced developed economies. The IMF projects GDP for emerging and developed Asia to total 6.3% in 2019, compared to 6.5% in 2018. 

While there is some confusion as to what exactly has been agreed to in the meeting between Trump and Xi at the G-20 Summit on December 1, it is clear that there won’t be an escalation of tariffs at the start of 2019, or for the next 90 days.

CFRA sees the move as a positive step toward resolving an issue that is a key risk to global growth.

Ultimately, we believe the two sides will come to an agreement on trade and tariffs will be removed. There is too much to lose otherwise.

For Trump, it is the risk of losing re-election in 2020 from a sharp decline in economic strength. For Xi, the Chinese economy is already showing signs of deterioration. While we are encouraged by simulative efforts, a full-blown trade war could knock the second largest economy in the world and the global economy into recession. 

With trade talks continuing and moving in the right direction, the dollar stabilizing (with the potential to decline slightly), fiscal and monetary stimulus in China and interest rate increases in the U.S. set to slow in the coming year, CFRA became positive on the emerging markets in October.

Valuation was a key part of the thesis. Trading at a 19.3% discount to its long-term average price-to-earnings ratio (P/E), the MSCI Emerging Markets Index is attractive.

The MSCI Asia Ex-Japan Index trades at a 12.9% discount. Both indices are projected to have double-digit earnings growth in 2019. As discussed above, solid GDP growth in the emerging markets will be a key driver for profit growth in the region. For comparison, the valuation of the S&P 500 trades in line with its historic average and is expected to report earnings growth of 7.5% in 2019. 

chart 2

For broad exposure to the emerging markets, CFRA recommends considering SPDR Portfolio Emerging Markets ETF (SPEM), which is ranked Overweight. SPEM is diversified geographically and includes exposure to Latin American, Europe and Africa as well as Asian markets – China (32% of assets), India (14%) and Taiwan (14%) are the three largest country holdings. SPEM earns positive cost factor rating inputs from CFRA.

Please consider registering for an S&P Global webinar I will be participating in titled “Emerging from Home Bias with Passive Strategies” on December 6 at 2 pm. Information here.

View CFRA, services and research including Marketscope Advisor here.

View brief video interviews with Lindsey Bell of CFRA:

Lindsey Bell’s picks: Apple, AI, Nvidia, Intel, semiconductors here.
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Recorded: MoneyShow Las Vegas, May 15, 2018.

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