Emerging markets have significantly underperformed developed markets this year, but just because EM is cheap on a relative basis doesn’t mean now is the time to buy. So far this year Turkish equities are down 50%, Argentinian equities are down 50% and Chinese equities are down 20%. It is important to examine the causes of EM weakness to determine whether or not current conditions are likely to persist. The two most apparent reasons for EM weakness are dollar strength (albeit modest so far) and China slowing.
The USD seems to have formed a solid base during the beginning of the year at around 90 on the DXY, rising above 96.8 in August. Even though the USD has been fairly range bound since June, the DXY could break above 100 before the end of the year. Since 2Q18 the USD is markedly stronger against not only EM currencies (TRY, ZAR, THB, MXN, CNY/CNH, BRL, MYR, ARS, CLP) but also DM currencies (EUR, GBP, JPY, CAD). Dollar strength is a result of continued hawkish monetary policy from the FED and rising US Treasury Bond yields, which draw money out of EM and into the US. This can be seen in the substantial outperformance of the S&P500 over the MSCI EM Index so far this year.
Beginning in late May the RMB dropped sharply against the USD by around 10% and this shocked EM economies, many of which are highly dependent on commodity exports that are priced in US dollars. In China, industrial production, fixed-asset investment and interbank rates have been weakening in tandem with the RMB. China has avoided a full scale stimulus that would further exacerbate its debt burdens, so it doesn’t appear that there are any golden parachutes to save EM economies. The PBOC utilizes its counter-cyclical factor to maintain a weak RMB, this helps buoy exports which make up approximately 20% of Chinese GDP. As the trade war intensifies with further tariffs it is unlikely that the PBOC will allow the RMB to strengthen on a sustained basis.
Those emerging economies that have significant USD-denominated debt burdens will continue to suffer as liquidity is drained from the global economy via tighter monetary policy and shrinking global central bank balance sheets. Of course, some EM economies will still provide good growth prospects over the long-term, but timing is everything when trying to catch a falling knife.
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