Emerging markets: focus on stocks, not the market, as you enter the fourth quarter

While investors take cover from US-Chinese trans-Pacific gales and local Asian thunderstorms, we stay the course. Keeping an eye on companies’ return on invested capital, and applying an active manager’s stock picking skills, we try to spot potential risks as well as opportunities in emerging markets.

Since August, the odds of the US and China reaching an agreement on trade seem to have improved, according to the Trade Tension Barometer calculated by Goldman Sachs (see chart). This index is based on four corporate and market indicators tracking trade proxies such as Chinese and US exporters, or companies benefiting or hurting from the Chinese yuan’s falling trend. A level of zero in the barometer means a trade agreement is out of reach, a level of 100 stands for a high probability of resolution.

Over the past six months, the correlation between the Goldman Sachs barometer and emerging-market equities has risen to a 0.4-0.8 range versus previous periods of lower positive or even negative correlation. So now that this indicator is improving, and given its higher correlation with the market, are we in for a relief rally? This seems doubtful. For one, the barometer may be up, but its rise in August isn’t convincing (see chart). What’s more, the trade row has become a major worry for businesses and investors, a development also reflected in the growing number of Google searches for terms such as “trade conflict” or “trade war”.¹

US-Chinese bickering worries Asian economies

Yet amid the constant drumbeat of trade-related news, this issue is sometimes blown out of proportion. On the one hand, the two behemoths on both sides of the Pacific can shrug off a worsening of trade relations. Only 5.1% of US companies’  revenues come from China, with US-related revenues of Chinese companies lower still at 2.8%.² In a recent study focusing on Chinese indicators such as electricity production, and corporate data such as capital expenditure, Goldman Sachs found that Chinese companies have been little affected by worsening trade relations so far.³ On the other hand, many Asian economies suffer when trans-Pacific shipments slow. Therefore, a worsening row between the US and China is a real concern to Asian companies.

While the US and China slug it out, we have three pieces of advice for emerging-market investors:

• Go domestic: Invest in businesses that generate the bulk of their revenues in their home market, not from exports. In the Vontobel Fund - mtx Sustainable Emerging Markets Leaders, for example, China accounts for 38% of the holdings, but only 3% of our Chinese companies are export-oriented.
• Go stock-specific: Rather than replicating other market participants’ top-down decisions such as “underweight China”, consider Chinese companies whose business is driven by structural growth trends, not the outcome of the trade dispute. These could be businesses benefiting from the rise of e-commerce across China.
• Go cheap: Use market downturns to increase existing or build new positions.

Eyes on trade talks, earnings improvement and monetary policy

We believe emerging-market equities remain attractive. There are a number of possible catalysts that could drive stock market returns in the fourth quarter:

• Easing trade tensions ahead of US elections in 2020: It’s reasonable to expect that ahead of next year’s elections, President Donald Trump will be keen to reach a deal with China to placate Midwestern farmers, who see their exports dwindling. In addition, American consumers start feeling the pinch of additional tariffs on Chinese goods via higher inflation readings. However, we doubt there will be a handshake before the end of this year.
• Relative economic improvement not yet priced in: According to Credit Suisse estimates, economic growth in emerging markets will exceed that of the US by 3.8 percentage points in the second quarter of next year, with this figure already factoring in a “weak” 6% Chinese rate for 2019. In addition, the latest Chinese purchasing managers’ manufacturing data (Caixin) of 51.4, the highest reading since February 2018, implies better exports. Leading indicators in emerging economies have become superior to those in developed countries, Credit Suisse says. With this in mind, it appears that the year-to-date underperformance of emerging-market equities relative to their developed-market counterparts isn’t justified.
• Earnings expectations improving: This holds particularly true in the technology sector, and in countries such as Brazil, Taiwan, South Korea, and China. For instance, some Asian mobile phone or telecommunication companies are benefiting from a faster-than-expected rollout of the latest 5G mobile phone infrastructure. However, the upward revisions of analysts’ earnings expectations have so far failed to translate into improved price momentum.
• Attractive equity valuation: Emerging markets still trade at a discount of 40% to developed markets based on the Shiller price/earnings ratio, which is close to historical lows. As long as trade uncertainties persist, a discount to the long-run average price/earnings ratio of 13.2 will persist, in our opinion.
• Further Chinese policy easing and stimulus measures: According to Credit Suisse, 13 out of the largest 15 emerging economies have loosened monetary policy, and Goldman Sachs expects the trend in China to continue this year. The country may also announce further measures to stimulate the economy after the meeting of the Communist Party’s Central Committee in October.
• Will the flows resume? According to JPMorgan, the monthly outflows from emerging markets decreased to 3 billion US dollars in September (data as of September 26) versus 19.3 billion dollars in August, now totalling 25.6 billion dollars so far this year. Flows may resume in the fourth quarter if some of the catalysts materialize.

Storms may rage, but fair weather will follow

As far as we are concerned, we remain cautiously optimistic. While the clouds on the horizon do have a silver lining, the trade “war” may become a self-fulfilling prophecy. Apart from that, investors need to keep an eye on broad economic developments (US economy, US dollar), as well as country-specific problems such as the protests in Hong Kong and in Indonesia, or the tinderbox that is the Persian Gulf.

¹ Various articles on this topic, e.g. “How markets are reacting to the US-China trade war”, ft.com, June 2, 2019 https://www.ft.com/content/2e453fd2-8203-11e9-b592-5fe435b57a3b

² According to index provider MSCI

³ “What micro data tell us about the impact of the trade war on China”, Goldman Sachs, September 19, 2019

Vontobel Fund - mtx Sustainable Emerging Markets Leaders