After a challenging 2018 in which emerging market debt logged negative full year total returns, 2019 has begun with an eye-catching recovery.
In the case of EMD sovereigns, all the losses of 2018 were erased by January 2019, and most EMD asset classes have added to or held onto their gains since then. So what next? While the journey for EMD will never be smooth on a month-to-month basis, we outline the key reasons why we think the positive start to 2019 can be sustained.
First and foremost, the biggest driver of improved sentiment has been an unexpected change in US monetary policy. Following four interest rate rises in 2018, US monetary normalisation was expected to continue well into 2019. However in early 2019, the US Federal Reserve (Fed) abruptly shifted to a much more dovish stance. This promptly led to the market pricing out any further US rate hikes in the whole of 2019.
As such, this implies a much more benign global liquidity outlook, with reduced upward pressure on US bond yields and the US dollar. In turn, this lessens pressure on emerging markets (EMs) to raise domestic interest rates. On the contrary, amid low inflation, some EMs could soon be in a position to cut domestic interest rates.
Secondly, the other big headwind for EMs, particularly in the second half of 2018 was the backdrop of increasing US/China trade tensions. Here too, the situation has certainly improved with the two sides agreeing to a ‘truce’ in December and subsequently engaging in ongoing talks aimed at a more sustainable trade agreement. Even if a headline-making deal is not announced, we think the likelihood of major escalation in the ‘trade war’ appears quite low.
This is because in order for this to happen, the US would have to extend tariffs to China’s Information and Communication Technology (ICT) exports. However, this would be much more damaging for the US’s own tech sector, including for the likes of Apple, whose CEO has warned of an impact akin to ‘a tax on US consumers’.
Thirdly, we can see that the economic growth differential between EMs and Developed Markets (DMs) has largely been on a declining path in the post-financial crisis era. In particular, this reflected slowing growth in most of the larger EM economies such as China, Brazil and Russia, coupled with a relatively resilient US economy on the other hand.
However, if consensus expectations are to be believed (owing more to slowing US growth rather than faster EM growth) the EM growth premium is now coming back. Other things being equal, this should imply a greater propensity of investment capital to flow out of DMs and into EMs. Furthermore, as depicted below, our research shows that in the past, periods of rising growth differentials favouring EMs tend to be supportive for EM currencies.
To summarise, even after the strong bounce-back of late, we remain relatively optimistic about the outlook for EMD in the rest of the year. This reflects big improvements in terms of two of the most important headwinds of the previous year, namely the global monetary/liquidity backdrop and US/China trade relations.
Furthermore, the case for EMD is strengthened by an improving growth differential, which should bolster both EM capital inflows and currencies. Coupled with some of the other more longstanding attractions of EMD, including potential diversification benefits and traditionally lower default rates, we feel there is still ample scope for the positive start to 2019 to be sustained.
Adam McCabe, head of fixed income – Asia and Australia, Aberdeen Standard Investments
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