Emerging markets: is the worst of the storm over?

A strong dollar and the US/China trade war has weighed heavily on emerging markets – when will these pressures let up?

Despite the predictions of a synchronised global upswing in 2018, so-called “growth markets” have provided investors with anything but this year. The MSCI Emerging Markets index peaked in January, but has since  continued to edge downwards. It reached its lowest point at the end of October, a decline of around 27% from its yearly high.

While a number of specific factors have helped drag down emerging market performance – from the Turkish president’s unorthodox views on monetary policy to further debt woes in Argentina – two main background factors have added to emerging market distress: a strong US dollar and the US/China trade war.

The strong performance of the US economy and resulting continued monetary policy tightening from the Federal Reserve has seen the dollar’s value rise in comparison with other currencies this year. This is usually bad for emerging markets, as it makes it more costly for emerging markets to service their large piles of dollar-denominated debt. This unnerves investors.

Compounding this, as the dollar rises, oil becomes relatively more expensive for buyers, widening the current account of oil-import dependent economies such as India.

As James Dowey, chief economist and  chief investment officer at Neptune recently put it at an investment conference: : “Are you positive on the dollar or emerging markets? You can only have one.”

Meanwhile, the US’s trade war with China has also dampened investor sentiment. In September, Christine Lagarde, managing director of the IMF, warned of the negative effect of tariffs on Chinese economic growth, already under pressure from Chinese authorities reining in credit.

This economic pressure, the IMF warned, could “trigger vulnerabilities” among other Asian economies that are integrated into regional supply chains, despite speculation that some emerging and frontier markets (such as Vietnam) will benefit from this re-organisation of supply chains.

However, as we approach the end of the year, is the worst of emerging market turmoil over? Have the two key background risks – a strong dollar and the trade war – started to recede?

Will the US dollar keep strengthening? 

Lower US economic growth should lead to a reduced likelihood of the US dollar strengthening any further.

In this regard, the mid-term elections could provide some relief, argue Pictet Asset Management. The win for the Democrats in the lower house makes the possibility of a further tax cuts much less likely. As a result, it is possible we will see the US economic growth cool “to more sustainable levels, the risk of a renewed surge in the dollar and US interest recedes,” adds Pictet.

However, there is now speculation that with the Democrats now controlling the House that president Donald Trump may finally have the support he needs for a large infrastructure spending plan. That would stimulate an already booming US economy, raising the spectre of faster rate rises from the Federal Reserve.

Infrastructure spending, says Paras Anand, head of asset management at Asia Pacific, Fidelity International, would “continue to push wages in an already tight labour market, and potentially challenge the current expectations around the Federal Reserve’s activity for next year”.

That would result in a stronger dollar, adding to emerging market headwinds. 

The best outcome for emerging markets is for the now divided US Congress to get tied up in partisan bickering, preventing it from passing any bills to further stimulate the US economy. Political gridlock, says Richard Buxton, head of UK equities and manager of the Merian UK Alpha fund, means: “The Federal Reserve will have less work to do. That would be good news for emerging markets – with fewer rate rises ahead and a dollar that’s not so strong. This, in turn, would provide some relief to emerging markets.”

A trade war ceasefire? 

Trying to gauge the process towards reconciliation between the US and China is no easy task.

First of all, the Democrat Party taking the House of Representatives in the mid-terms is unlikely to change the course of Trump’s policy towards China.

Trade and foreign relations are primarily the prerogative of the executive branch of the government. At the same time, many Democrats somewhat agree with Trump’s stance on China. As Nick Wall, co-manager of Merian Strategic Absolute Return Bond Fund, notes: “Belief that China has engaged in unfair trade practices is not purely a Republican trait.”

Instead of looking to internal US politics, China watchers are looking towards a scheduled meeting between Trump and China’s president, Xi Jinping, in Buenos Aires at the end of November. And there is bullish speculation and rumours suggesting a deal between the two economies may be on the cards.  

In a recent press conference, Trump referred to China’s Made in China 2025 programme, which aims to move the country's manufacturing up the value chain and see it take the lead in key future industries. Trump said: “China got rid of their China 25 because I found it very insulting ... I said China 25 is very insulting because China 25 means in 2025 they're going to take over economically the world. I said that's not happening.”

China, however, has not officially abandoned its Made in China 2025 project, despite quietly downplaying it. This, says China expert Bill Bishop in the Axios Sinocism newsletter, has led to speculation that the US and China have already worked out a deal which will be finalised at the G20 meeting. Officials shelving Made in China 2025– at least its use as a slogan– may likely be part of any such agreement between the US and China.

Bishop, however, thinks it is more likely that Trump simply misspoke. 

At the same time, says Bishop, there are rumours that vice premier Liu He, a top economic official, may visit the US before the Trump-Xi G20 meeting in late November if it appears there is progress towards at least the framework of a deal. “If Liu does schedule a Washington visit expect markets to get excited,” says Bishop.

However, even if some positive steps are made, any deal made is likely to be superficial. Both countries are likely to remain committed to seeing a “decoupling” of their economies.

From the US perspective, US businesses’ reliance on China-located supply chains is still a risk, while original grievances such as Chinese state-subsidies and lax enforcement of intellectual property rights are unlikely to be properly addressed. Meanwhile, from the Chinese perspective, the episode will have underscored the need to become less reliant on the US economy and confirmed their suspicion that the US hopes to prevent China’s rise.

At the same time, however, any deal which could prevent the scheduled increase of US tariffs on $250 billion worth of Chinese goods or reverse those already in place is likely to be welcomed by regional companies and the markets upon which they are listed.

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