The nascent recovery in emerging markets (EMs) has been thrown into question by Trump’s election. While the concerns warrant attention, we still see compelling reasons to invest in developing economies.
After 10 strong months, investor sentiment toward EMs has soured. Since the US election, rising US interest rates and a strengthening dollar have threatened to hurt EM countries and companies. Trump’s promises of protectionist policies have alarmed countries from Mexico to China. And from Brexit to the recent Italian referendum, there are growing signs around the world that populist trends are threatening to reverse globalization, which has benefited the developing world for decades.
But let’s put some perspective on the risks. The shifting geopolitical order may dilute the power of US trends over the developing world. Favorable domestic economic trends in EM countries could offset potential damage from US policies. And opportunities can still be found in EM companies that are relatively immune to the uncertainty emanating from the US.
What can past market crashes teach us about the current one?
New Geopolitical Order?
The geopolitical order is shifting towards emerging powers. China’s regional influence in Asia has risen. Russia’s resurgent influence in Ukraine, Hungary, Bulgaria and several former Soviet republics in Central Asia has defied sanctions from the West.
The International Monetary Fund (IMF) and the World Bank are no longer the sole source of emergency financing for emerging countries. Global institutions are less effective in resolving regional conflicts. In short, emerging countries are becoming less reliant on external sources to generate growth and provide emergency support.
Asserting Economic Independence
Developing countries are also asserting their economic independence. Improving economic growth in many developing economies is driven by domestic trends—not by the US. For example, Russia and Brazil are shifting from recession toward recovery. Accelerating growth in more EM economies can help offset the impact of China’s deceleration, in our view.
Inflation has largely been tamed across the developing world in countries such as Brazil. Poor performers such as Venezuela are the exception. And real interest rates are low enough to be a stimulating factor across many developing countries.
External balances have adjusted significantly. As a result, EM economies are generally less reliant on foreign capital—and therefore less vulnerable to rising interest rates in developed markets (DMs).
Concerns about a stronger dollar may be overdone. For many export-oriented EM companies, a weaker local currency versus the dollar should support profitability, as their products and services become more competitive abroad.
Where Are the Opportunities?
After distilling the macroeconomic risks, investors can discover diverse opportunities. For example, equity investors can focus on high-growth companies that are positioned to profit from domestically driven growth drivers. Some of the most profitable and compelling secular growth technology companies in the world today are in China, where companies command an ever-growing share of spending by the rapidly growing middle class.
Companies with attractively valued stocks also deserve attention, after years of neglect by global investors. Today these include industrial commodities companies in Russia that benefit from low costs of production and are well positioned for both a domestic and a global recovery. Korean financial institutions also look extremely attractively valued in the face of asset-quality improvements and steeper yield curves.
Applying a valuation lens to companies with quality and stability can also be rewarding. Examples include consumer-staples companies in emerging countries with strong brands that command loyalty from an aspiring middle class.
Valuations of EM equities remain attractive versus their DM peers (Display). It may be time to rethink the “political risk” discount embedded in emerging stocks, given the dramatic political upheavals that are rocking major developed countries.
Fiscal Prudence Returns to Latin America
Political reform is also helping to shape fixed-income markets. Take Latin America, where a crackdown on corruption is unfolding in countries like Argentina and Brazil. After rampant spending and graft in the commodity-fueled boom years, today’s more business-friendly governments are advancing fiscally sustainable policies that favor growth. And with inflation becoming increasingly contained in some countries, many hard-currency bonds in the region look attractive.
Of course, emerging markets will face plenty of challenges. And it will take time to understand the impact of changing US policies on the developing world.
Given the uncertainties, a flexible cross-asset approach can be rewarding. We think the key to constructing a resilient EM portfolio is to combine equities, debt and currencies, with stringent security selection. There are certainly real challenges to be reckoned with but, by getting a grip on the risks, we think investors can gain conviction to stay in EM through challenging times.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Morgan Harting, Alliance Bernstein