A huddle of negative factors cooled investor sentiment towards emerging markets in 2018. Some of these factors have reversed and more could follow.
After a disappointing second half of 2018, when emerging markets (EM) struggled against the weight of negative earnings revisions and rising trade tensions, the first quarter of 2019 has proved a more rewarding period for investors. The MSCI Emerging Markets index advanced 9.9% in US dollar terms and share-price volatility receded slightly. There were two big drivers of this sentiment change, namely a lowering of interest rate expectations and Sino-US trade talks.
From around November 2018 onwards, we saw a reversal in US rate rise expectations, continuing the indecisive pattern that has prevailed during the post-financial crisis era. The US Federal Reserve in its communications highlighted slower growth in major economies and heightened political uncertainty, including trade tensions and Brexit. A pause in US rate rises, combined with record low levels of inflation in most emerging countries, should allow EM central banks to lower rates in 2019.
Sino-US trade tensions remained a topic of intense interest during the first quarter, albeit with a more promising tone than last year. The two countries held discussions aimed at securing long-term trade commitments and, with talks underway, the US extended the deadline for the introduction of its next stage of tariffs on Chinese exports.
Chinese weighting rises
In other news on China, the MSCI announced an increase in the weight of China A shares in MSCI Indexes. Increases will take place in three steps over the course of 2019, and should result in the weight of A-shares in the MSCI EM index reaching 3.3% by November 2019 from 0.7% today. The Chinese government released its economic forecast for 2019, pointing to a slowdown towards 6% GDP growth from last year’s 6.5%. It also announced a series of tax cuts aimed at stimulating the domestic economy.
The broadly positive macro newsflow over the quarter comes at a time when estimates for companies in emerging markets and beyond are being revised downwards. It was against this uncertain backdrop that most EM companies reported full-year 2018 financial results in the closing weeks of the quarter. The results of each company played a big part in determining relative performance outcomes over the quarter.
There are some short-term events that we are watching which could have an impact on emerging market performance in the second quarter. These include the outcome of the Sino-US trade discussions, the result of India’s national elections and signs of stabilisation in economic activity in China and globally. We expect broadly market-friendly outcomes in each of these areas, albeit this cannot be taken for granted.
With 2018 reporting mostly behind us, we gained confirmation that companies in the portfolio are accessing growth across a diverse range of countries and sectors. We will be looking for signs of stability in earnings expectations following months of downward revisions. The recent shift in global interest rate policy away from tightening towards a resumption of rate cuts, should provide a boost to confidence and aid stability. While we are typically exposed to companies with above-average earnings growth prospects and stronger-than-average balance sheets, an improvement in the overall corporate backdrop would help build confidence that the long-term growth drivers for emerging markets remain intact. This is also likely to be a necessary pre-requisite to close the emerging market valuation gap to MSCI World.
We remain excited by the powerful combination of technology adoption, urbanisation and services sector growth that is evident in emerging markets. We expect a highly selective, stock-focused approach will continue to prosper through accessing high return-on-equity companies, operating in structurally growing industries.