Emerging market – Any silver lining amid volatility? August 30, 2018
Is volatility here to stay? Yes. Are we seeing a series of economies blow up in a repeat of the Asian Financial Crisis of 1997? No.
Author : Sherman Tam Cheng Wei

Emerging market – Any silver lining amid volatility?

This year investors have had a blunt reminder that emerging markets are risky assets. An escalating Sino-US trade tensions, slowdown in China economy and an invincible US dollar strength coupled with tighter Us monetary policy which could derail EM equities have all contributed to the 8% decline year-to-date (as of 24 August 2018) for the MSCI Emerging Market Index.

Any silver lining amid volatility? Source: Hub Consulting Inc.

Is volatility here to stay? Yes. Are we seeing a series of economies blow up in a repeat of the Asian Financial Crisis of 1997? No.

In this article, we will tackle these pertinent issues.

FIGURE 1: Emerging markets are facing challenges

Is volatility here to stay?

As US Federal Reserve start raising their interest rates faster than expected, it makes the emerging market assets becoming less attractive. Recent financial crisis in Turkey has make things worse because it further reduces investors’ appetite for riskier assets and intensifies the movement of foreign capital from higher-yielding assets to relatively safer ones in developed markets. With the above reasons, this explains why US dollar has been appreciating strongly this year (see Figure 2). On top of that, concerns on China economy slowdown and intensifying global tension has fueled anxiety about the global economic growth and corporate earnings outlook.

Emerging countries that are reliant on external borrowings to fund economic growth and large current account deficits such as Turkey and Argentina have felt the heat. Currencies of both aforementioned countries have depreciated about 40% against the US dollar year-to-date. Yet both Turkey and Argentina are relative outliers within the EM space.

In other words, with trade disputes as well as tighter US monetary policy dominating headlines and both US and China in the late stages of an economic cycle, some volatility is to be expected for the remaining months of 2018.

FIGURE 2: Dollar led capital outflow in EM space

Silver Linings of Emerging Market

However, the tone is much more upbeat from a fundamental perspective. Many other EM countries, especially in Asia, appear healthier with improving current account balances as well as lower external debt to GDP ratio (refer to Figure 3). And structural reforms in countries such as China and India are likely to put economies on the path to a more sustainable long-term growth.

FIGURE 3: EMs are strong enough to weather another shock

Looking solid from economic fundamentals

According to the data released by the International Monetary Fund (IMF) by end-June 2018, the annual growth rate for emerging market over the next 5 years will remain at high level, while the growth rate of GDP for the developed markets will be declining, as shown in Figure 4. This is a very compelling reason to take a harder look at the emerging region of the world, and position portfolios for this coming shift.

FIGURE 4: IMF forecasts that EM's economic growth will outpaced developed markets

After a gloomy spring, economic data coming from the emerging markets space is starting to improve, at least relative to expectations. This year’s equities underperformance can somehow relatable with a rapid deterioration in emerging markets economic prospects. From late April through mid-June, the Citi EM Index of Economic Surprises plummeted from +31 to -12.

Long story short, economic data went from reliably beating expectations to consistently missing expectations. Since mid-June things have started to look better, indicating that economic data is strengthening relative to expectation.

FIGURE 5: EM equities underperformance coincides with disappointing economic data

Higher potential return that comes with rare pocket of value

From a valuation standpoint, the MSCI Emerging Market Index is trading at PE ratios of 12.1X and 10.8X based on estimated earnings for 2018 and 2019, way below to its estimated fair PE ratio of 13.5X (as of 24 August 2018) (see Table 1).

Table 1: Valuation and Earnings Growth for MSCI Emerging Markets Index

2018 2019 Fair
PE Ratio (X) 12.1 10.8 13.5
Earnings Growth (%) 6.3 11.5 -

Source: Bloomberg, iFAST compilations. Data as of 24 August 2018.

As of 27 August 2018, an investor’s potential annualised return for the emerging equities by end-2020 is a compelling 17.7% compared with its developed counterparts like MSCI World (6.7%), US (2.7%) and Europe (7.3%). Therefore, we maintain our conviction in the positive view for emerging market equities moving forward given that the recent downfall within emerging market space has created pockets of value, in our view.

FIGURE 6: Expected Annualised Returns by end-2020

The bottom line

Emerging market equities are always more volatile than those of developed markets and as a result, news and expectations, both positive and negative, tend to get overplayed. That seems to be the case here, where all the possible negatives of the current market situation are priced into emerging markets, while the US market is taking a much more optimistic view. They can’t be both right.

Since the Asian Financial Crisis in 1998, key improvements across EMs, such as stronger economic fundamentals, higher foreign currency reserves and lower inflation, indicating that an imminent emerging marker crisis an overblown statement. In today’s EM, a repeat of the financial crisis that spread from Thailand’s currency collapse in 1997 seems unlikely.

In all, we are maintaining our positive stance on emerging market equities. For investors who share the same view as us, one can tap into the investment opportunities residing with global emerging markets via Eastspring Investments Global Emerging Markets Fund.

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