Backtrack 12 months and many investors anticipated that the recent rebound in emerging market sentiment was about to reverse. November 2016’s election of Donald Trump as US president sparked heavy sell-offs of emerging market currencies, following a series of protectionist policy statements on the campaign trail. Meanwhile, promises of increased infrastructure spending and tax cuts raised the spectre of a rise in inflation. At the time, some market-watchers thought this could lead to the Federal Reserve tightening its monetary policy at a faster pace than it had initially planned, causing investors to pull their money from emerging markets.
Admittedly, there was a dip in the MSCI Emerging Market index immediately after the election outcome was announced. The yield on US 10-year treasuries also shot up, surpassing the 2 per cent-mark. However, over the longer-term concerns that the emerging market gains of 2016 would be lost proved unfounded over this year. In fact, the MSCI Emerging Market index has risen to its highest point in six years and has outperformed the FTSE All-Share index. As a result, the former is trading at 13.7 times blended forward earnings, according to Bloomberg estimates. That’s its most expensive valuation since 2009. However, it falls to 12 times blended forecast earnings for 2018. Meanwhile, yields on emerging market sovereign debt declined as investor demand increased. The question is, will this momentum continue next year?
The great unwinding
The Federal Reserve’s decision to unwind its $4.5 trillion quantitative easing (QE) programme was arguably the most geographically far-reaching monetary policy decision of 2017. While local currency emerging market bonds took a knock following the announcement, there was nothing like a repeat of the 2013’s taper tantrum. When former Fed chairman Ben Bernanke signalled an end to the Fed’s QE programme that year, a large number of external investors pulled their capital from emerging markets, with the risk premium looking a lot less attractive. Interest rates have also been raised three times since Mr Trump was elected to the White House, from a range of between 0.5 per cent and 0.75 per cent to between 1 per cent and 1.25 per cent.
Incoming Federal Reserve chairman Jerome Powell said in November that the Fed will continue to shrink its balance sheet steadily for the next three or four years, with the final size in the range of $2.5 trillion to $3 trillion. In addition, interest rates will continue to be gradually raised. John Williams, who sits on the Fed’s Open Markets Committee, said a rate rise in December “makes sense, at least based on the information I have today”. He expects three further increases next year, as interest rates return gradually to “a normal level” of about 2.5 per cent.
However, it seems unlikely that there will be the same level of outflows – or even net outflows at all – as a result of rising US interest rates next year, since these rises have been very well flagged by the Fed. European Wealth Group investment strategist Richard Stammers said he expects US interest rate rises to be modest and well managed by the Federal Reserve as the process of turning off the money taps of quantitative easing continues. “The risk, of course, is that US inflation surprises on the upside and forces rates to move higher faster,” Mr Stammers says. “That would hit sentiment, but it is a scenario to which we currently give a low probability.” In November, emerging market inflows from non-residents were $17.1bn, according to the Institute of International Finance, representing 12 straight months of net inflows. That’s in contrast to the $19bn in capital losses in the immediate aftermath of the US election.
Head of research at emerging market specialist asset manager Ashmore, Jan Dehn, believes that investors will actually increase their allocations to emerging markets as the Fed begins to unwind QE. Since the Fed and the other three QE central banks only bought their own government bonds, the interventions induced investors to alter their allocations in favour of the QE-sponsored markets, he says. “While every single asset price elsewhere has gone up in the quantitative easing period, there is one area where asset prices have gone down – emerging markets,” he says. That means that emerging markets now offer both carry and potential capital gains, he argues.
What’s more, while external capital inflows have recovered during the past two years, capital losses during the three years to 2016 were far greater. Net inflows were just $20bn in 2014, while emerging markets suffered net capital outflows of $620bn in 2015 and $550bn in 2016, according to the Institute of International Finance. The think tank forecasts that external net capital flows are on track to exceed $115bn in 2017 and $164bn in 2018, far less than the aggregate $1.15 trillion in outflows during the prior three years. Mr Dehn believes that institutional investors are yet to fully respond to a more positive outlook for emerging markets. “The reality is that most institutional investors are constrained by various processes, which means that they typically respond to material changes in the market with a lag of 18-24 months,” he says. “Global markets began to anticipate the Fed’s announcement last week as far back as early 2016. This means that the bulk of institutional money has yet to respond and creates a positive technical backdrop for emerging markets going into 2018.”
A more stable China?
As a large importer of goods, the fortune of the Chinese economy is one of the leading indicators of the health of many other emerging market economies. Sentiment towards China has recovered during 2017, after a shaky 2016. The pace of capital outflows to the region has also slowed. During the first 10 months of 2017, net outflows were $22.8bn. However, in October, China gained direct investment of $24.6bn, compared with outflows of $20.9bn during the first quarter of the year. What’s more, with the onshore bond market now completely open to foreign investors, overseas demand for Yuan-denominated government bonds was at a record high of $12bn during the third quarter.
The International Monetary Fund (IMF) upgraded its forecasts for Chinese gross domestic product growth by 0.1 per cent for 2018 to 6.5 per cent. However, this is down from the 6.8 per cent forecast for 2017. The IMF expects the People’s Republic to maintain its expansionary fiscal policy, particularly through increased public spending investment, in order to achieve its target of doubling real GDP between 2010 and 2020. What’s more, the global think tank says supply-side structural reforms, which are focused on cutting excess industrial capacity, should also help drive growth.
However, with the Chinese government committed to shifting from growth fuelled by infrastructure and manufacturing spending to a model based on services and domestic demand, the country’s debt pile has continued to grow. At the end of 2016, China’s debt to GDP ratio stood at 256 per cent, according to the Bank for International Settlements. That’s up from 195 per cent at the end of 2012. The IMF expects debt to non-financial institutions to exceed 290 per cent by 2022. It’s unclear if 2018 will be the year the chickens come home to roost for the Chinese economy, but it seems likely the country is storing up trouble for the future.
While the Chinese government’s long-term strategy to reduce its steel and iron imports may have weighed on commodity-exporting emerging market economies in Latin America, as well as Russia, during the past two years, there was some relief during 2017. Following the Organization of the Petroleum Exporting Countries’ (Opec) May agreement to cut daily global oil production by 1.8m barrels a day until March, the price of Brent Crude has risen by 15 per cent so far during 2017. Following a meeting among the world’s largest oil producers in Vienna, that output agreement has been extended throughout 2018.
Although it's unlikely US monetary policy will have emerging market investors running for the hills next year, US tax reforms – which boosted the US dollar – do pose the risk of a rise in US inflation. That could dent emerging market sentiment. Given the country-specific risks of investing in these disparate emerging market economies, we favour actively managed funds rather than index trackers. Our most recent emerging market buy tip is Aberdeen New India Investment Trust (ANII), which aims to achieve long-term capital appreciation by investing in companies incorporated in India, or that derive significant revenue or profit from India. Over three and five years this trust has made share price returns of 49 per cent and 110 per cent, respectively, beating its benchmark, MSCI India Index, which made40 per cent.
