2017: emerging markets recovery or relapse?

The November election of Donald Trump as the next US president marked a turning point in this, albeit modest, recovery. Since 10 November emerging market currencies such as the Mexican peso and the Turkish lira have been sharply sold off. That same month inflows into emerging market debt and equity are estimated to have plummeted to their lowest level since July 2013, according to the Institute of International Finance. Protectionist policies and the spectre of further interest rate raises from the Federal Reserve next year make emerging markets a less attractive place for external investors to put their cash.

The UK’s vote to leave the EU may have been a political curve ball to financial markets in June, but they were no more prepared for the election of Mr Trump later in the year. In fact, so unexpected was his electoral success that much of the discussion around the state of emerging markets by media, analysts and fund managers has related to commodity prices, US monetary policy and the health of the Chinese economy. This time last year we were wondering to what extent low productivity growth, a greying population and legacies of the financial crisis in the developed world would hamper investor sentiment towards emerging markets. A year on and these issues are still very relevant to the fortunes of these markets. However, now there is the added uncertainty over the extent to which Mr Trump’s protectionist polemic will translate into policy, which will not truly be known until next year when he takes his seat in the White House.

The dawn of ‘Trumponomics’?

Whether the Fed decides to maintain or raise rates – and the pace at which it does this – will be one of the most important determinants of the direction of third-party capital flows into these markets next year. Post-financial crisis, ultra-low rates in the US – as well as other developed economies – have sent capital flooding into emerging markets, as investors were willing to take additional risk in search for superior yield. Corporate bond issuance surged to $630bn (£501bn) or 2.5 per cent of emerging markets’ (as a whole) GDP by 2013, compared with just $13bn in early 2000. Suggestions that the central bank would curtail its bond-buying programme that year caused a huge number of external investors to pull their funds from emerging economies, with the risk premium looking less attractive – the so-called ‘taper tantrum’.

Fed chair Janet Yellen is expected to announce an interest rate rise before the end of 2016. Minutes from the Fed’s November meeting showed “most participants” expressed a view that it could become more appropriate to raise the target range for interest rates “relatively soon”, providing the economy continued to move towards the committee’s targets of 2 per cent inflation and maximum employment. This is in contrast to “some participants” during September’s meeting.

However, some expect more frequent rate rises next year following Trump’s election and pledge to increase public spending. This is their highest level in more than a year. The President-elect has previously been critical of the Fed’s super-loose monetary policy for creating what he terms a “false economy”. Trump’s campaign-trail pledge to spend up to $1 trillion on upgrading the nation’s infrastructure, increasing jobs and economic growth, in addition to proposed tax cuts, could trigger inflation. Meanwhile, an increase in the fiscal deficit could also exacerbate inflation. The increased likelihood of imminent rate rises is starting to be priced in the market. Ten-year US treasury yields surged to 2.44 per cent at the start of December, compared with 1.77 per cent a month earlier.

Some fund managers reckon even if the Fed does increase rates next year we will not see a repeat of the 2013 taper tantrum. Abbas Ameli-Renani, global emerging markets strategist at Amundi, reckons it is unlikely that the impact of a possible US tapering will be as negative for emerging markets as in 2013. “Emerging market countries have much lower external vulnerability, and investors are not as overweight as they were when the taper tantrum hit,” he says.

Increased levels of corporate debt made emerging markets particularly vulnerable to the curtailment of external flows and currency devaluations in the years preceding the taper tantrum. However, the proportion of dollar-denominated debt held by emerging markets such as China has increased during the past five years, according to data from the Bank of International Settlements. An increase in US economic growth next year would strengthen the US dollar and rising rates would increase the cost of servicing this debt for emerging countries in 2017.

China’s spillover effect

A slowdown in Chinese growth was partly to blame for the outlook for emerging markets faltering during 2015. That year, GDP grew 6.9 per cent, down from a post-crash peak of 10.4 per cent in 2010. The People’s Republic is forecasting a full-year figure of 6.7 per cent during 2016, which it achieved during the first three quarters. The improvement in sentiment is therefore due to expectations moderating, rather than a belief that GDP will return to a double-digit figure. The International Monetary Fund has estimated that the Chinese economy will expand at the slower rate of 6.2 per cent in 2017 (see table).

However, with government spending propping up growth, China has accumulated a heavy debt pile. Worryingly, the gap between its debt level and GDP growth is widening for the worse. Admittedly, China does have solid foreign-exchange reserves of around $3.1 trillion, which act as a buffer in case of an increase in US rates. However, this stockpile is also in decline following repeated devaluations of the Yuan by the Chinese central bank. While its chickens may not come home to roost during the immediate future, the world’s second-largest economy could be storing up trouble for the longer term.

China is shifting from growth fuelled by manufacturing and infrastructure spending to a model based on services and domestic demand. As the world’s largest importer of commodities such as steel and iron, China’s dialling down of investment in fixed assets will continue to cause pain for exporting regions, such as Latin America. During the 15 years to 2015 China’s share of global imports increased to around 10 per cent from 3 per cent. However, the IMF says a well-managed transition will benefit the global economy in the long term, with more sustainable growth in the country and a reduction of risks associated with disruptive fiscal interventions from the Chinese government.

However, there could be some good news for commodity exporters on the horizon. It’s not just Donald Trump that reckons more public spending is needed to spur growth. The Organisation for Economic Development’s (OECD) chief economist, Catherine Mann, argues that global public investment is needed in order to boost trade and employment rates. If the OECD’s advice is heeded, this would increase aggregate demand for raw materials around the world, particularly benefiting emerging exporting economies.

What’s more, the Organization of the Petroleum Exporting Countries (Opec) has agreed to cut oil production next year by 1.2m barrels a day, in a bid to tackle oversupply of Brent Crude in the market. If successful, it should go some way to maintaining the price of Brent Crude around $55 a barrel. However, it’s worth noting that this is a fragile accord – which could be frustrated if exempted countries such as Nigeria and Libya were to increase production.

The prospects for emerging markets next year seem more uncertain than they were 12 months ago. Given the country-specific risks of investing in these regions we prefer actively managed funds to index trackers. There is likely to be more volatility in flows next year as we gain a clearer picture of what shape US trade and monetary policy will take. However, we reckon there are still growth opportunities for those willing to take a long-term view, plus valuations are typically more favourable than for developed economies.

Our most recent emerging markets fund buy tip is Newton Global Emerging Markets (GB00BVRZK937), which we reckon will keep providing returns post-Trump's election. The fund's manager takes a thematic approach to selecting stocks over a range of emerging markets including India, China and the Philippines. It aims to outperform the MSCI EM index by more than 2 per cent a year over a five-year rolling period. Other defensive funds focused on quality stocks include Fidelity Emerging Markets (GB00B9SMK778), which has a high exposure to emerging Asian countries, and JPMorgan Emerging Markets (JMG), which has a quality bias and is most exposed to India. For more of the best funds as well as companies to invest in to gain exposure to emerging markets growth opportunities, keep an eye out for our new emerging markets series in the new year.