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After a challenging 2018, we are optimistic that 2019 could turn out to be a more constructive year for emerging markets. On the one hand, a global growth slowdown, ongoing uncertainty about US trade policy, and the impact of contracting G4 central bank balance sheets on liquidity and flows will continue to pose headwinds to risk assets. However, we think that EM should outperform as the US “catches down” to the rest of the world, as EM-DM growth differentials stop shrinking, and the US Federal Reserve (FED) adopts a much more cautious stance in the face of a US slowdown and diminished risks of an inflation overshoot (which should anchor real UST rates and push the USD weaker). Furthermore, China growth should stabilize in the first half of the year due to the lagged effect of recent defensive easing measures, forthcoming fiscal stimulus and a likely cooling down of US-China trade tensions. EM fundamentals remain reasonably strong, while valuations are close to the wides of summer 2015 and already pricing a global slowdown. Given the current environment, we see compelling EM opportunities in US dollar credit, particularly in high yield, local currency fixed income, and FX.
2018 was a perfect storm for EM assets. Following the synchronized global recovery of 2017, the US recovery gained momentum on the back of the Trump administration’s aggressively pro-cyclical fiscal policy, while all other economies slowed down. The FED was forced to tighten policy more aggressively than what the market was ready to price due to several key factors: US GDP growth that was projected well above trend, a strengthening US labor market, wages recovering, and higher inflation partially pushed by rising oil prices. This led to a sharp repricing in US Treasury (UST) rates and a stronger US dollar. Meanwhile EM was hit by rising trade tensions with China and the knock-on effect that this had on global trade flows and investor sentiment. Though that is now behind us, we believe that 2019 will not be without its challenges. Last year’s unsynchronized recovery is giving way to a synchronized slowdown, which can prove challenging for risk assets if global growth falls sharply below trend and recessionary fears begin to set in, like they did in early 2016. US trade policy will continue to generate uncertainty amid fears that the US will follow up on threats to hike and broaden tariffs on Chinese goods and impose tariffs on all car imports, both of which could accelerate the slowdown in global trade growth. G4 central bank balance sheets will also shrink on aggregate in 2019 for the first time since Quantitative Easing began as the FED balance sheet run-off will continue and the European Central Bank ended net asset purchases at the end of 2018. The reduction in overall liquidity may potentially dampen the return potential of EM assets.
However, we think that EM should be able to outperform this year as the US “catches down” to the rest of the world, and EM-DM growth differentials, which are strongly correlated to capital flows into EM, stop shrinking. Far from outperforming the rest of the world as it did in 2018, US growth is likely to revert to trend and possibly fall below trend by the end of 2019 due to the impact of past monetary tightening on rate sensitive sectors of the economy and the fading of the fiscal stimulus effect in the context of a divided government with little appetite for consensus. In addition to the slowdown in growth, the tightening in financial conditions caused by the sharp correction in stock markets during the fourth quarter and the recent pull back in inflation expectations, should likely push the FED to slow down its rate hiking path. We don’t think the hiking cycle will come to a permanent halt though as the market is currently pricing. In addition, the FED will likely recalibrate its balance sheet run-off, as hinted by members of the Federal Open Market Committee in early January. Overall, these conditions should help anchor UST rates and push the US dollar weaker, potentially offering support to EM assets so long as recessionary risks remain far off.
China’s ability to stabilize its growth following last year’s slowdown will be key to determining this year’s trajectory for global trade growth and EM valuations, particularly in trade-sensitive assets. We anticipate that the current growth downtrend, which was caused by past credit deleveraging and rising trade tensions, will continue before stabilizing in the second quarter as recent and forthcoming policy loosening measures begin to have a more noticeable impact on growth. These measures include an easing of monetary policy focused on stimulating financing to the private sector and fiscal easing through a wider budget deficit and a higher local government issuance quota. China’s weakening property market and its impact on consumer behavior, however, should cap any meaningful recovery. The evolution of US-China trade tensions will also be key. While we see a conclusive, permanent deal as elusive, given the big gaps still separating both sides, we think that both sides are highly incentivized at this stage to showcase enough progress in the next few rounds of negotiations to forestall any further tariff actions in March and shore up investor sentiment.
Overall, we think that EM fundamentals are reasonably strong. As government debt levels are higher compared to previous cycles, EM countries have limited space for fiscal stimulus in response to a tightening in global liquidity conditions, but EM has maintained adequate real interest rate buffers all through 2018. With inflation comfortably within the target ranges of most EM countries, we think that central banks should be in a position to hold or, in some cases, cut rates in 2019. Overall current account balances are also firmly in check. Even countries with the highest deficits and those that struggled in 2018, notably Argentina and Turkey, are currently undergoing significant adjustments on the back of much weaker currencies and a collapse in domestic demand.
We think that current valuations are also more compelling following last year’s aggressive repricing. The current spreads of the JP Morgan EMBI Global Index (EMBIG) are now approximately 405 basis points, which is well past the levels seen during the 2013 taper tantrum. Spreads are closer to mid-2015 levels when the world was gripped by fears of a hard landing in China and a global slowdown, but still below the early-2016 wides, when global slowdown fears morphed into a proper risk-off market. We don’t believe such fears are justified at the moment. The EMBIG High Yield Index looks particularly compelling, with implied spreads of approximately 600 basis points. We think that Argentina’s sovereign credit could benefit as a result of the ongoing aggressive unwinding of the fiscal and current account imbalances under the auspices of the IMF program. We also believe that President Mauricio Macri will secure re-election in October as growth recovers, inflation gaps lower, and FX volatility subsides. If President Macri is re-elected, this should guarantee another four years of policy normalization. We also find local currency fixed income attractive. Excluding Argentina and Turkey, real yields within EM local fixed income are around 3% given tight monetary policies and low inflation in most jurisdictions. We think that Russian local currency government bonds are interesting, given that Russia’s macro policy remains far too tight and the yield curve remains far too steep in anticipation of sanctions. Without a new catalyst, we think that will be delayed though, and, if enacted, contain limited provisions. We also think that EM FX looks attractive after weakening significantly relative to G10 currencies, particularly given our view that further US dollar strength will be hard to come by. We think that many currencies are trading cheap-to-fair value, even when stress tested for liquidity and funding pressures. We think that the Brazilian real is worth reviewing as the market will likely be forced to reprice Brazil’s business cycle this year as it gains confidence in the new Bolsonaro administration’s ability to deliver a market-friendly reform agenda.