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Emerging markets: think global, buy local

16 January 2019

As we start 2019 GAM Investments’ Michael Biggs believes emerging market (EM) macro fundamentals are sound and valuations are attractive, but cautions that global uncertainties could pose risks to the outlook.

EM fundamentals are sound, despite near-term growth risks

In our view, EM macro fundamentals are sound. In early 2018, the EM trade balance started to move into deficit and when capital inflows into EM slowed, EM FX reserves started to fall and EM currencies came under pressure.

In the second half of 2018, EM started to adjust, led by countries like Argentina and Turkey. The EM trade account moved back into balance and it is currently fluctuating around zero (Chart 1).

Chart 1: EM trade balance

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.

Capital flows have stabilised, EM FX reserves have started to edge up once again (Chart 2) and EM FX has rallied. The slowdown in capital inflows in the middle of 2018 has two implications for EM. Firstly, these inflows are well correlated with domestic lending and, in our view, likely contributed to a slowdown in credit growth in the second half. The negative credit impulse suggests downside risks to GDP growth in Q4 and Q1.

Chart 2: EM balance of payments

Source: Bloomberg, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


Chart 3: Capital flows and domestic credit 

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


But more positively, we believe it also means that the current level of capital inflows into EM is relatively low and, as a result, capital inflows are more likely to rise than fall from current levels. If capital inflows rise, this should boost domestic liquidity, support credit growth, return the credit impulse to positive territory and support real GDP growth. We believe FX reserves would likely increase as well.

Chart 4: EM credit impulse and growth

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


Credit growth in EM is still below nominal GDP growth and, as a result, the debt-to-GDP ratio is falling. This sustained improvement in the EM ‘balance sheet’ also supports further gains in credit growth and we anticipate the positive credit impulse to ensure that EM growth is back above 4% by the middle of 2019.

Moreover, despite last year’s currency depreciation, EM inflation has remained contained and lower commodity prices, not least for agricultural products, are a positive for the outlook. When EM growth is strong and inflation contained, EM assets tend to perform well.

EM valuations

In addition, EM asset valuations are, in our view, attractive. The recent rally in EM yields has brought them back down to their historic averages (6.5% to 7.0%), but EM FX appears cheap. As shown in Chart 5, EM FX performance is reasonably well correlated with starting real effective exchange rates (REER). The current average REER for EM is 91.5 and average future returns from these levels have tended to exceed 5%.

Chart 5: EM FX valuations and future changes

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


Given the sound fundamentals and valuations we consider attractive, we are cautiously optimistic about the outlook for EM assets. We expect that the JP Morgan Government Bond Index-Emerging Markets (GBI-EM) could return 5% to 10% for the year. However, to trigger these returns, we need the US dollar to stabilise or weaken from here, and this is likely to require an improvement in the growth outlook in the euro area and China.

Global risks

The key driver of EM local currency debt in the short term is the US dollar (Chart 6) and this in turn depends, at least in part, on relative growth rates in the US versus the rest of the world.

US growth reached 3.0% yoy in 2018, but it is expected to slow towards 2.0% in 2019 as the fiscal stimulus wanes. We do not expect a recession in the US, but we do expect slowing growth to contain further US interest rate increases. With headline and core PCE inflation both below 2% and oil off its highs, slowing US growth should mean that further rate rises from here are contained.

Chart 6: USD and EM FX

Source: Bloomberg, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


The US outlook is therefore supportive for EM: growth is expected to be strong enough to support the rest of the world, but not so strong as to necessitate aggressive interest rate hikes. More important for EM might be what happens in the rest of the world.

China growth slowed towards the middle of the year and policymakers responded to trade war-related growth concerns by easing monetary policy in Q3. Immediately new borrowing increased. However, this was not sustained into Q4. New borrowing declined again, the credit impulse remained negative and property sales started to contract.

Chart 7: New lending in China

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only


We expect Chinese policymakers to use both monetary and fiscal policy to stabilise the economy and if trade pressures start to dissipate, we expect quarterly GDP growth to rebound back to above the 6% level. However, if this view is to be correct, we need to see the lending numbers pick up in Q1.

Chart 8: China credit impulse and property sales

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


We have similar concerns for the euro area. Growth slowed as expected to more sustainable levels in the first half of 2018 after a very strong 2017, but it then weakened further in Q3 as changes in environmental regulation hurt auto production in Q3. We expected a rebound in Q4 as this shock unwound, but, as Chart 9 shows, growth has remained weak.

Chart 9: Euro area growth and PMI

Source: Haver, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


This sustained weakness could be due to slower demand from China and the ‘yellow jacket’ demonstrations in France and, in our view, the euro area fundamentals remain solid. Credit conditions continue to improve, and credit growth still appears to be on a rising trend. Our base case is that production rebounds in Q1 2019 and GDP growth stabilises at 1.5% yoy. So far, however, the signs of stabilisation remain elusive.

A bullish EM view will depend in part on a rebound in global growth and early signs could come from the China lending numbers and euro area purchasing managers’ indices (PMI). We are cautiously optimistic about the outlook for EM assets given the sound fundamentals and attractive valuations, and we anticipate the GBI-EM to return 5% to 10% for the year. But we will wait for evidence of the rebound before we position ourselves more aggressively.

Regional divides

We mentioned earlier that the EM trade balance has returned to zero after widening into deficit in mid-2018 (Chart 1). These aggregate trends mask some sharp divergences at a regional level. As Chart 10 shows, the trade deficit for Asia has continued to widen, whereas the trade deficit for the rest of EM is at record surplus.

Chart 10: Trade balance in EM by region

Source: Haver, GAM Investments, as at 31 December 2018.

Past performance is not indicative of future performance. For illustrative purposes only.


We believe at least part of this is due to oil and we expect the gap to close as the recent oil price decline starts to become evident in the trade numbers. But trade shocks aside, real import growth has exceeded export growth in Asia. Unless export growth picks up, import growth, and by implication Asian domestic demand growth, will have to slow. This is likely to happen via a combination of a weaker currency and higher rates.

The reverse is true in the rest of EM, which means that demand growth can strengthen without imbalances starting to build. This provides room for either lower rates or a stronger currency.

Looking at specific countries, in this context we believe the outlook is positive for Argentina, Turkey and Russia, but more challenging for India and Thailand.

Country themes

In our opinion, the two adjustment cases of 2018, Argentina and Turkey, could provide the most interesting opportunities in 2019. In both cases, the goods trade balance went from substantial deficit to balance, helped by a surge in interest rates but at the cost of a collapse in growth. The contraction in activity still continues.

In both cases, if the policy framework holds, interest rates could decline significantly. The risk in Argentina is that slow growth causes either a change in government or the current government to abandon its orthodox policy positions. Growth, the fiscal numbers and political developments will need to be monitored closely.

In Turkey, the growth slowdown has caused bad debts to the banks to rise sharply. The questions are: 1) whether the banks can handle the rise in bad debts; 2) whether the government is able and willing to recapitalise the banks if the losses escalate, and 3) if capital inflows reverse due to bank concerns.

In both cases, we believe there is potentially material upside, although we will be monitoring the risks in both countries very carefully.In our view, the attractive valuation story is Mexico. The exchange rates remain very cheap on a real effective exchange rate basis and real yields are as high as they have been in a decade. By some estimates, real yields in Mexico exceeded those in Brazil late last year.

Mexico faces political risks both on domestic and foreign fronts, but with a modest amount of FX stability, one could see a decline in inflation and a sharp rally in rates.

In contrast, we are more cautious on Indonesia, Thailand and Russia.

In Indonesia and Thailand, all appears well except for the balance of payments. Domestic demand growth is running at levels that generally cause a current account deterioration and export growth has turned negative due to weak Chinese demand. Either exports will have to increase or demand growth will have to slow through higher rates and a weaker currency.

In Russia, the macroeconomic fundamentals look sound despite the recent oil price decline. Until recently, the fiscal balance was improving, the trade surplus was rising, inflation was stabilising at low levels and real rates were high. While the recent oil price and Russian ruble weakness take some gloss off the picture, the underlying fundamentals remain solid. The problem in Russia is political. At some point, an increase in sanctions appears likely.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
The investment program described herein is speculative and entails substantial risks. The investment program is not suitable for all investors and does not represent a complete investment program. Investing in foreign instruments or currencies can involve greater risks and volatility due to currency rate fluctuations, political, economic or market instability, tax policies, and political, regulatory and other conditions. These risks are greater in emerging market countries. Emerging markets can have less market structure, depth, and regulatory, custodial or operational oversight and greater political, social, and economic instability than developed markets. The value of securities denominated in emerging market currencies are affected by changes in currency rates or exchange control regulations, restrictions or prohibition on the repatriation of currencies, application of tax laws, including withholding taxes, changes in government administration or economic or monetary policy or changed circumstances in dealings between nations.
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