The sell-off in emerging market assets since the turn of the year caused by trade tensions, US interest rate rises and the strengthening dollar has been overdone, according to Morgane Delledonne, ETF Investment Strategist at BMO Global Asset Management.
The MSCI Emerging Market Index has lost 10.5% in the year-to-date and 18.5% since its peak in mid-January. Meanwhile emerging market currencies have been under pressure led by Turkey, a potential debt-default re-run in Argentina and the uncertainties caused by the elections in Brazil.
Delledonne points out that this has led to a bout of risk-off sentiment among global emerging market investors yet she believes there is low contagion risk to otherwise complex global EM ETF flows.
"This was highlighted by minimal net outflows and large net inflows to several EM countries year-to-date, notably into China and South Korea focused ETFs, reflecting possible dip-buying strategies," she adds.
She says that another example was when Turkey's sovereign credit rating was downgraded by both S&P Global Ratings and Moody's in September on the back of the weaker lira, rising inflation and a large current-account deficit.
"EM bonds fell across the board, but EM bond ETFs recorded modest net outflows over the week of the announcement, suggesting investors saw little contagion risk from Turkey to the rest of EM."
Delledonne admits that while US equities continue to rally, the sell-off in EM and European equities suggests market participants have partly priced in the risk of a trade war outside US markets.
"However, the slowdown in EM economic activity in the second quarter may have also dampened market sentiment towards EM as suggested by the inflection of the upward trend in earnings growth expectations since August."
Indeed, emerging market economic growth has decelerated since the beginning of the year from 5.8% year-on-year in the fourth quarter last year to 5.3% year-on-year in the econd quarter 2018. But it remains high relative to developed markets and furthermore surveys on economic activity (PMIs) have lost momentum while staying above the expansion threshold.
"Nevertheless, emerging market corporates' earnings are high compared to prior cycles' peaks while equity valuations are close to multi-year lows. EM equities are about 30% cheaper than developed market equities, based on relative long-term price/earnings ratios."
On the dollar, Delledonne is sanguine, suggesting it should remain broadly stable but on the current US/China trade tensions, it is likely to lead to a "binary outcome."
"If the US and China eventually come to an agreement in the coming months, it would likely benefit global equities and have limited direct economic impacts. On the other hand, if the trade dispute escalates we could see negative economic impacts in the medium-term with an increase in inflation from higher tariffs and a drag on the global economy."
Delledonne cites estimates from the IMF that would suggest the estimated drag to the global economy would be worth 0.5% by 2020 if the tariffs so far threatened are all implemented. In such a pessimistic scenario, Delledonne suggests a "correction" would take place in US equities as the market wakes up to a lose-lose scenario.
"The possible rise of US inflation may force the Federal Reserve to increase interest rates more aggressively than anticipated, which will likely be disruptive for markets globally," she adds.
A changing market
More positively, emerging markets now account for around 65% of global GDP and this is only likely to grow, at least according to the IMF. Meanwhile the composition fo the MSCI Emerging Market index has also changed significantly in the past decade with the proportion of cyclicals declining.
"Technology has been the fastest growing sector in terms of percentage of the index for the last ten years, representing just 10% in 2008 to almost 30% today. In contrast, the energy and materials sectors, which then accounted for almost one third of benchmark, account for 15% today.
"Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage, superior profitability and lower earnings variability, which suggests they are aptly managed and can quickly adapt to economic changes, Delledonne concludes.
