Outlook on Emerging Markets

RD12136

EquityLow Volatility, High UncertaintyEmerging markets equities posted a strong January, extending their 2017 gains. Volatility has returned to global equities in 2018, however, and emerging markets have been no exception. Although the MSCI Emerging Markets Index weakened in February and March, it rose 1.4% in the first quarter in contrast to key developed markets equity indi-ces, which retreated slightly (Exhibit 1). However, certain emerging markets countries were caught in the crosshairs of trade tension, notably China, whose mainland equity market finished down more than 4% for the quarter.

The prospect of rising inflation, rate hikes, a stronger US dollar, and a trade war remain prime sources of this increase in volatility for global and emerging markets equities. It is notable that emerging markets volatility still remains below average and only began to rise in February from unusually low levels in 2017 (Exhibit 2). More importantly, we are experiencing inflation of a good kind, underpinned by economic growth. In our expe-rience, slow, steady global growth of the type we have today is the best possible backdrop for emerging markets equities.

Trade Skirmishes or Trade War?Equities around the world traded down following US tariff announcements on steel and aluminum imports on 1 March. Subsequently, on 22 March, the United States levied new tariffs on an estimated $50 billion of Chinese technology imports as a result of its Section 301 investigation of Chinas alleged intellectual property rights abuses. While steel and aluminum tariffs would increase US metals prices and raise costs for down-stream industries like automotive, appliance, and beverage manufacturers (potentially making them less competitive), exemptions for certain regions or countries will ultimately mitigate their full impact. These include Mexico, Canada, the European Union (EU), Australia, South Korea, and Brazil. Of the $48 billion of US steel and aluminum imports

Summary In a world where relatively

few financial assets can be considered cheap, we believe emerging markets offer good value. Equities, in particular, offer the lowest valuation of any major equity region, with comparable or better ROE and dividend yields.

Global protectionism is currently our equity teams biggest concern. That aside, emerging mar-kets profitability, dividend yield, and free cash flow is improving.

We see good bottom-up growth opportunities ahead and, should value tailwinds begin to form, this would offer a new area of opportunity within emerging markets equi-ties.

As long as US rate hikes are driven by growth, we believe emerging markets debt should continue to perform well in absolute terms and relative to other types of fixed income.

History shows that emerging markets debt does not underperform amid rising rates, contrary to popular belief.

We maintain our construc-tive outlook for emerging markets debt and are closely monitoring key risks, such as Fed policy error and slowing growth.

APR2018

Exhibit 1Strong Start to Q1 Began to Fade in February

-10

-5

0

5

10

SSE Composite (China)

S&P 500MSCI EAFEMSCI WorldMSCI EM

(%)

FebruaryJanuary March

Q1 2018

As of 31 March 2018

Source: MSCI, Shanghai Stock Exchange, S&P

2

last year, exemptions would have excluded 63% of the total, or $30 billion worth (Exhibit 3)1.

Comments from Chinese Premier Li Keqiang on 26 March helped allay some anxiety, however, and boosted markets. The premier stated that China would not force foreign firms to transfer technology to Chinese partners and that China would look to strengthen its intel-lectual property rightsaddressing two important areas of concern for the United States. As part of ongoing negotiations, China has offered to import more semiconductor chips from the United States, which will reduce its purchases of South Korean and Taiwanese chips. Although the situation remains fluid, the Sino-American dialogue is active and is one the market will continue to closely monitor.

In the meantime, retaliation from other countries, particularly China, is a major concern. The EU is considering taxing US bourbon and blue jeans. On 2 April, China announced plans to tax 128 US food products, primarily fruit, wine, and pork. The Trump administration responded on 3 April, naming about 1,300 Chinese products that could be added to its list of taxed items. The next day, China struck at the highest-value US imports, which include aircraft and agricultural products, notably soybeans, with proposed 25% tariffs at an estimated $50 billion cost to the United States.

As the United States and its trading partners trade countermeasures, we see no big victories in a trade war. Decades of globalization and the emergence of multinational businesses have resulted in complex supply chains that crisscross the globe. New trade restrictions are likely to open the door to unintended results. The fluidity of global supply chains could simply create new winners and losers in emerging markets rather than meaningfully improve and reset the terms of trade.

For example, US tariffs on solar panels and washing machines, first introduced in 2011, were initially limited to China, Taiwan, South Korea, and Mexico. Imports did not significantly drop, however. The source countries simply changed, with Asian economies, such as Malaysia, Singapore, Thailand, and Vietnam, becoming the new suppliers (i.e., trade diversion). Critics of US steel and aluminum tariffs note they raise the cost of building new US energy infrastruc-ture, reduce the cost competitiveness of US-based auto and appliance makers, and discourage foreign investment. Steep tariffs may also potentially undermine stimulus effects from recent US tax cuts and deregulation. In a best case, we believe US protectionism will be lim-ited to trade skirmishes and will stop short of a global trade war if all parties negotiate better terms of trade that are mutually acceptable. The unpredictability of US trade policy and countries responses, however, poses a key risk that investors must factor into their decisions.

Short-Term Clarity on ChinaSignificant changes are happening in China that could affect emerging markets over the next few decades. Landmark legislation has removed limits on the number of terms President Xi Jinping can serve, putting new emphasis on his political philosophy, Xi Jinping Thought, and his vision for Chinas future. China is also dismantling some 15 agencies, replacing them with a host of powerful new bodies. These developments provide better short-term clarity about Chinas economic objectives, as they are likely to align with President Xis focus on reducing financial leverage, promoting growth, and projecting Chinas soft power abroad. They also pose longer-term risk factors, such as greater state involvement in the private sector.

A question that Western policymakers are increasingly asking is whether it is reasonable to expect changed behavior by China, or if it will be more effective to seek ways to counter Chinas approach. Chinese economic liberalization has been modest and social freedoms continue to be at odds

Exhibit 3Two-Thirds of US Steel and Aluminum Imports Exempted

US Imports of Steel and Aluminum, by Trading Partner and Tariff/Exemption Status (Billions)

Exem

pted

from

Tarif

fs th

roug

h

May

1 ($

14.8

) Not Exempted

($17.9)

Exempted fromTariffs ($15.3)

South

KoreaBrazil

Argentina

EU

Mexic

o

Canada

Others

Russ

ia

China

Japan

UAE

TaiwanTurkeyIndia

Vietnam

As of 26 March 2018

Source: Peterson Institute for International Economics

Exhibit 2Normalizing EM Volatility

0

10

20

30

20182017201620152014201320122011

Std. Dev.

MSCI EM Index Volatility

Average=17.0

As of 27 March 2018

Source: FactSet

3

with Western ideals. As disciplined investors, we consider the broad context but we always return to the fundamental question of whether opportu-nities in Chinese companies look better now than before.

To that point, we are somewhat reassured that capacity has been reduced among Chinese state-owned enterprises, which are also consuming less credit than before. In addition, the private sector, which is dominated by small to mid-size companies, is quite strong and is contributing to the economys growth. Corporate debt levels, which have risen at an accelerating pace in the past several years, have moderated and, in some cases, declined. We expect the Chinese economy to continue to be closely managed, and welcome its emphasis on better quality, more sustainable growth. Although valuations on average have moved higher over the past two years, we see good growth opportunities and hold positions in attractively valued Chinese technology, consumer-related, and financials compa-nies across our large cap and small cap emerging markets portfolios.

A Relative Bargain in Todays TermsIn a world where relatively few financial assets can be considered cheap, we believe emerging markets offer the greatest value. They offer the lowest valuation of any major equity region, with comparable or better return on equity and dividend yield (Exhibit 4). The natural enemies of emerging markets are in retreat: The risk of negative real growth has greatly receded, and the world is free of major crisis. Importantly, company fundamentals continue to improve across most countries and sectors. Earnings growth expectations were revised higher throughout the first quarter and returns were more broad-based, led by energy, health