Perspective - Managers' views
2019 will be a better year for emerging markets
There is a building consensus that 2019 will prove a better year for emerging market (EM) assets than 2018.
There is a building consensus that 2019 will prove a better year for emerging market (EM) assets than 2018. Given that the overall equity index fell over 14% in 2018, almost no EM currency delivered a positive return and the Emerging Market Bond Index (EMBI) lost 5.3%, this does at least set a low bar. Nonetheless, when we look at the likely macro drivers, the picture is somewhat mixed. Despite the mixed signs, we maintain that 2019 will be a better year for EM than last year.
Will EM enjoy a return home to 2017 returns?
Beginning with the good news, we do expect to see a weaker dollar in 2019. An end to the Federal Reserve (Fed) hiking cycle, and growing deficits, should weigh on the global reserve currency and buoy emerging markets in the process. There is a well-established correlation between the dollar and EM assets. A weaker dollar sees EM equities outperform their developed market (DM) counterparts and is associated with tighter spreads for hard currency EM debt. Taking our currency assumptions from our current forecast, the dollar index is on track to weaken by around 2% in 2019 and a further 2% in 2020.
Nor is the weaker dollar good news purely from a market perspective. As we wrote in a July 2018 research paper1, a growing body of academic research suggests that the dollar's dominant role as an invoicing currency in global trade amplifies its impact on the international flow of goods and credit. This effect is particularly marked for emerging markets, which tend to exhibit a greater reliance on the dollar. Essentially, a weaker, or cheaper, dollar boosts credit growth and trade by making both things cheaper in local currency terms for all countries except the US. This does function with more of a lag, however, meaning that while there is some potential for short-term upside on EM credit and the trade multiplier, for much of 2019 the lagged effects of dollar strength could prove a headwind for EM growth before reversing in 2020. (Though we would note that credit itself operates with a lagged effect on economic activity).
In particular, the implied path for the trade multiplier is of concern for emerging markets, suggesting that for a given amount of global GDP growth, global trade volumes will see less of a lift in 2019 than in 2018. The situation is not catastrophic; the multiplier should remain in line with the post crisis average rather than collapsing to 2015 levels.
Summing up; on the one hand, a weaker dollar is generally positive for EM assets; on the other, a weakening global trade and a slowing Chinese growth is hard to overlook, particular for EM equities.
The two stories are not entirely incompatible. Dollar weakness is associated with the relative outperformance of EM vs DM assets, rather than necessarily implying absolute gains. A weaker dollar combined with weaker global trade therefore argues more for relative trades within equity, EM vs DM.
In local currency debt, a disinflationary environment could be quite helpful, particularly alongside dollar weakness. EM central banks would be able to pause, end or even reverse their 2018 hiking cycles, initiated to protect in part against dollar strength. This should support the asset class, which, denominated in local currency, would also gain more generally from dollar weakness. Hard currency debt spreads, meanwhile, should benefit from the weaker dollar and an end to the Fed's hiking cycle. If we are right, then 2019 may not be a repeat of 2017 for emerging markets, but at least it will be better than 2018.
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