Scylla, Charybdis and emerging market equities

Through the narrow path

In Greek myth, Scylla and Charybdis were two immortal and irresistible monsters who preyed on sailors in the narrow straits of Messina. Plotting the path between this vengeful pair proved too difficult for many. Even Odysseus barely survived the ordeal.

Investors in emerging market equities are currently being subjected to a similar examination at the hands of higher US interest rates on one side and rising protectionism on the other.

We continue to lean portfolios towards emerging market equities, in particular Asia, in the expectation that these trials will be passed. We explore why in more detail below.

The devil...

It is still difficult to discern the impact of escalating trade tensions in the economic data. Front-loading of orders and shipments ahead of the imposition of tariffs will likely distort our view for a while yet too.

Nonetheless, emerging market assets, particularly in Asia, have underperformed the rest of the world seemingly in anticipation of these negative economic effects.

We need to be wary of overconfidence here. We cannot pretend to know for sure that the escalation seen in the last month is part of a crude negotiating strategy on the part of the US administration.

However, as November’s US midterm elections loom larger, we see economic and political self-interest helping to de-escalate the scrap. In the meantime, the potential for capital markets to be dragged into a disciplinary role suggests investors will again need to call upon their stores of composure to see this through.

...and the deep blue sea

Absent the aforementioned tensions, the currently healthy global economic backdrop is traditionally one that sees emerging market equities outperform more often than not (Figure 1).

EM tends to outperform during non recessionary periods

US consumption is booming, investment is finally picking up more forcefully around the world, and global trade volumes are following suit.

As a result, corporate profitability in the region and forward earnings expectations have been rowing against the tide of falling prices. However, it is not only trading tensions that have been unnerving emerging market investors, but also a perhaps overly-rigid reading of the historical playbook.

The past would teach us that higher US interest rates and a rising dollar are the times to be wary of emerging markets. Businesses that have borrowed heavily in dollars can find increasing mismatches between domestically oriented revenues and dollar interest rates. So go the economies in question too. However, as we have pointed out before, the degree of mismatch (and mismanagement) this time around looks to be more isolated1 (Figure 2).

EM economies have gradually reduced their trade deficits

Argentina, South Africa and Turkey look vulnerable to higher US interest rates, but the emerging market space in aggregate looks more able to digest them given lower dollar exposures and better-balanced domestic economies.

Investment conclusion:  wait out the hiatus

Some hiatus following last year’s phenomenal ascent in emerging market equities was inevitable. The fundamental inputs for further outperformance over the next 6 – 12 months remain present and correct in our opinion, though patience and composure are likely to still be required.

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