Emerging market (EM) nations have seen an abundance of newsflow during the first half of 2019, whether prompted by President Trump’s ongoing trade war with China or more recent dispute with Mexico; Turkey’s travails continuing to cause economic upheaval domestically; or India successfully conducting the world’s biggest democratic election. Given this ever changing market backdrop for EM equities, we thought it would be timely to outline our current regional allocation views, highlighting our preferred regions, those where we maintain a more neutral stance, and those areas towards which we are more cautious.
To start with China, we are modestly positive on this market and believe the likelihood of further domestic stimulus measures should offset the increasingly contentious US relationship. Cyclical growth issues caused by the trade war and slow external growth can be mitigated by additional monetary, fiscal and industrial policy – while the structural shift to focus on domestic consumption, stable debt ratios, improved quality at the macro and micro level plus capital support from the internationalisation of capital markets remains supportive.
That said, given the Trump administration’s application of 25% tariffs on nearly all Chinese exports to the US, we have lowered our growth outlook for China to reflect the weaker global economic environment amid the recent escalation of trade and tech tensions. We have cut our 2019 GDP growth forecast by 50 bps to 6.0% and for 2020 by 70 bps to 5.5%.
Given recent market declines, we favour the more attractively valued H-Share (which are traded on the Hong Kong stock exchange) opportunities presently over the traditional A-Share stocks which are traded on the mainland. It is interesting to note that the MSCI indices have commenced their A-Share exposure as of June 2019 and therefore we expect to see more activity in this space and will monitor closely. In the short term, our focus remains on the domestically-driven beneficiaries of stimulus (insurance, property, white goods, autos) while a potential increase in export-orientated stocks in the event of any trade war resolution remains a possibility.
The announcement of the restructuring of Baoshang Bank – a city commercial bank based in Baotou, Inner Mongolia – that entailed a temporary takeover for one year due to credit risk served as a reminder of the ongoing bank clean up that has been underway for several years. The fact China's smaller banks are gradually but steadily falling under the regulatory knife is not, in our view, a symptom of growing financial system risks. Quite the opposite; we believe it is part of the de-risking process of deleveraging and risk reduction, at the expense of growth. In our opinion, there appears little systemic risk, due to early and coordinated regulation efforts in keeping with the financial clean up, which has been going on for more than two years. The People’s Bank of China (PBoC) has tried to reduce collateral damage by reassuring the market that it will provide sufficient liquidity to the system, that Baoshang Bank is an isolated case and they have no plans to take over another bank. In short, China’s central bank sought to calm investors, saying regulators are not planning any more such moves for the moment.
We have a positive view on Turkey, where valuations are attractive following recent market turbulence, as we feel the top-down supports are strong. The risk is that soft capital controls could potentially migrate into hard capital controls and, as such, we favour companies with stable foreign earnings, pricing power and no debt, such as consumer staple Coca Cola Icecek. Russia is another highly favoured market – in our view its creditworthiness is good and corporate fundamentals are strong, in addition to its increasing yield and good coverage ratios. We are positive on domestic cyclicals in the steel sector and selected oils. Hungary, Colombia and Greece also are all considered attractive currently, although these less liquid markets can be vulnerable to changing risk sentiment toward the US dollar in the asset class and EU domestic election issues.
The Indian market has experienced a post-election euphoria bounce and companies expected to benefit from Prime Minister Modi’s second term are already materially higher. Yet, we believe fundamentals rather than political / thematic issues are taking a front seat. To date these have relied heavily on the health of the US economy; however with peak US growth arguably behind us and trade concerns rising we feel it is important to maintain a good awareness of any downside risks. Modi's strong re-election result has taken away a good deal of uncertainty in the Indian economy; employment generation expanded for the 14th consecutive month, with the gain in May the largest since February. This may partially reflect business optimism around the election outcome as well as expectations of near-term support for growth. We will be closely monitoring the data in the first quarter following his re-election, looking for specific market stimulus and reform impetus.
We currently maintain a neutral stance towards India as the market is expensive even though policy support and strong domestic growth are encouraging. We are positive on banks which have come out of a long stress cycle and have the potential to become defensive plays, in our view, even if the economy witnesses a further slowdown, given their better growth outlook and improved balance sheet ratios. In addition, the Reserve Bank of India (RBI) is expected to cut rates since GDP growth numbers were weak, inflation is benign and liquidity is still tight.
Our view toward Taiwan has improved, due to more attractive top-down and bottom-up metrics. The market still suffers from mixed data and the developed market (DM) growth outlook still weighs on it. Moreover, the upcoming presidential election at the end of the year and limited scope to shift monetary or fiscal policy suggests Taiwan is not in an optimal position and therefore we still retain an element of caution. Select technology and China-sensitive positions would benefit materially in the event a US-China deal is agreed. Meanwhile Korea, considered the bellwether of global trade, has been navigating through some deep export-orientated air pockets. However, given large falls compressing valuations, we believe much has now been discounted. The market remains inexpensive but the economy is still struggling in terms of growth, policy options and high levels of domestic debt – hence we remain neutral.
Our cautious views on Mexico and Brazil have also improved in recent weeks. With the Mexican trade war seemingly reaching a resolution or abeyance of further tariff allocations, we think valuation and currency entry points offer a relative buy point to select high quality liquid names with positive free cash flow (FCF). In Brazil we anticipate there may be more upside in the third quarter as modest government reforms are accomplished.
Following it being one of our preferred markets for the last two years, we have become more cautious towards Saudi Arabia. Gulf Co-operation Council (GCC) markets faced a sharp correction in May as rising concerns over a US escalation of tensions with Iran and a weak global backdrop saw heavy profit taking. The S&P GCC composite Index fell 5.43% over the month. This was at the same time as the first stage of the market’s MSCI Emerging Market Index inclusion, which saw almost USD 8 billion trade on the Tadawul Stock Exchange. Saudi now holds a near 3% weight in the MSCI EM Index, while the total Middle East and North Africa (MENA) weight in the MSCI EM Index is now 3.3%; we expect that may increase to 5.4% by June 2020.
Despite the increasing tail risk of a potential Middle East oil price supply shock, we do not give this a high probability in reality. We expect the US / Iran rhetoric to subside in coming quarters and consider the likelihood of an all-out war to be low, although not minimal. We anticipate the GCC markets will focus more on the strong domestic recovery which is underway on the ground. Continued high oil prices and new sovereign bond programmes have given the regional governments confidence to resume spending programmes. Meanwhile we believe stronger domestic investment should filter through to bank loan growth and corporate earnings this year and next.
Malaysia has been something of an enigma. Despite recent falls, a loss of earnings means valuations are not as cheap as implied (as a result of earnings per share falling at a material pace as the stock prices). The market is gearing up to deal with the aftermath of regime change and poor economic growth, but there is no firm evidence yet and valuations are slightly elevated as it is a domestically-focused market. However, at a stock level this is a difficult market, hence we remain cautious. Indonesia is a domestically-focused high growth market with a new government and therefore more difficult at the stock level. We apply a more select approach to stock selection. The Philippines, Peru, Chile, Qatar and Thailand are markets we consider expensive, with no short-term positive catalysts on a relative basis.