December 10, 2018
Peter Wilson , Global Fixed Income Strategist
Fourth Quarter Presages a Better 2019 for EM
- 2018 has been a negative year so far for many asset classes in dollar terms. Emerging markets (EM) have taken their share of the pain. However, they have broadly outperformed in the fourth quarter, as equity and credit-market falls have been driven from the U.S., and valuations have supported EM assets.
- There may still be surprises in store after a year full of geopolitical and policy risk. Yet if our expectations are correct, and near-term risks subside, 2019 may provide a better environment for EM performance.
What it May Mean for Investors
- We raised our guidance on EM fixed income from neutral to favorable earlier this year, and since mid-2018, we have upgraded our EM equity guidance from neutral to most favorable. Cheap valuations should provide a useful cushion against ongoing, near-term volatility. Our outlook for economies and the relative policy settings between the U.S. and the rest of the world also suggests more fundamental reasons for EMs to outperform next year.
Year to date (as of November 30, 2018), 2018 has been a tough year across almost the whole range of asset classes. And yet, it is worth pointing out that the drivers of this broad market decline have not been constant over the course of 2018. Different markets have had their share of pain at different points: U.S. Treasury securities in the first quarter, EM assets over the summer, U.S. equities more recently, and (of course), oil.
Most non-U.S. asset classes are lower in dollar terms, in part, because of the broad-based dollar rally this year. The dollar’s strength has been driven by a number of factors: quarterly Federal Reserve (Fed) rate increases; U.S. fiscal and trade policies (resulting in rising expectations of U.S. growth compared to those of global trading partners); and the sheer range of geopolitical risks and policy uncertainty that has boosted dollar demand from risk-averse accounts.
The strong-dollar view is not clear-cut
This narrative of overarching dollar strength needs qualifications (see the chart below). On the basis of the Dollar Index (DXY), developed market (DM) currencies have fallen some 5% versus the dollar in 2018. Yet, almost all of these losses came during the three-month period between April and June; and while DXY has been edging higher lately, the second half of the year may be viewed more as a trading range rather than a sustained dollar rally.
More importantly, the three months since early September have seen a clear decoupling between DM and EM currencies. As the dollar has been edging higher against the euro, yen, and pound, EM currencies appear to have formed a base and are recovering. While it is early days yet, we believe that currencies may be early predictors of turning points in fixed income and equity asset class sentiment—perhaps because of their liquidity and ease of trading for early-moving investors and traders. We think that this decoupling from dollar strength and recovery in EM currencies may be a good sign for performance in the coming year.
EM valuations improving at the end of 2018
There are a number of reasons why EM sentiment is looking better in the fourth quarter. The first, and most obvious, reason is that several EM markets plunged dramatically earlier in the year, and the asset class is due for a bounce. To put it another way, valuations have become so attractive that they provide a good cushion against ongoing market volatility as well as still-present geopolitical and policy risks.
To end November, the DXY has risen 5.5%, but the dollar on this basis (around 97.00) is still broadly mid-range between the 103.80 highs and the 88.25 lows of the past four years. On the other hand, the JP Morgan EMCI hit a low of 60.30 back in early September—13.4% lower on the year and 45% lower since the post-financial-crisis high in early 2011. On a trade-weighted and inflation-adjusted basis, most EM currencies now appear on the cheap side of our fair-value tracking models.
Similarly, emerging equities and fixed income appear attractively valued versus alternatives after the big hits seen earlier in the year.1 On the fixed income front, we upgraded our view on EM sovereign debt (U.S. dollar-denominated) as yields moved above 7%—the highest levels seen since the global financial crisis—and as spreads widened beyond 400 basis points (100 basis points equals 1%) over Treasuries and to extreme levels of near 200 basis points against comparably-rated U.S. high-yield corporate debt.
2019 may see headwinds reversed
There are also reasons to believe that EM currencies are pre-empting a better environment for EM assets more generally in 2019. While many risks remain, our macro-economic forecasts suggest that, while the U.S. likely will grow more slowly next year, growth in emerging economies will be sustained. Further stimulus from fiscal easing should be constrained in the U.S.; however, China is already embarking on stimulus measures to ease the economic slowdown and more may be seen in 2019. We expect the Fed to end its current cycle of interest rate rises sometime in 2019. If this scenario comes about then the dollar’s strength against DM currencies also may be set to peak in 2019. Given the cheap valuations and the anticipation of some of the 2018 headwinds reversing, we believe that the fourth-quarter stabilization of many EM exchange rates may be presaging better performance for EM assets in the coming year.