Global factors continue to be headwinds for EM
The short-term outlook for emerging markets is mostly driven by the fluctuations of the US dollar and the pace of developed market monetary policy tightening, while ongoing trade disputes could bring further bursts of volatility. In contrast, respective governments’ policy responses could offset some of the negative effects from these external shocks. For example, the recent actions from central banks in Russia and Turkey helped to stabilise emerging markets and lowered equity volatility.
The US dollar should remain broadly stable, or only gradually appreciate on a trade-weighted basis, as the Federal Reserve normalises its monetary policy. The US dollar index (DXY) has declined by 2.9% since mid-August despite strong economic growth in the US, suggesting this deprecation possibly reflects the widening of the US trade deficit (from US$42bn in May to US$51bn in July). Therefore, the potential knock-on effects of the trade negotiations for the US trade deficit are likely to have a greater influence on the dollar as we move forward into next year.
Trade friction likely to influence the medium-term outlook for EM
The US-China trade dispute is likely to lead to a binary outcome, i.e. a trade deal or a trade war. 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. The IMF has estimated that the drag could amount to 0.5% by 2020 if the tariffs threatened by various trading partners are all implemented. In this pessimistic scenario, where the US cannot negotiate a trade deal with China, we would expect a correction in US equities as market participants realise that it could be a lose-lose situation. 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.
Emerging markets are no longer a cyclical play
At an aggregate level, EM accounts for almost 60% of the global GDP in 2018 and this share is expected to grow, according to the IMF. Besides, the composition of the MSCI Emerging Market index has changed over the past decade and the proportion of cyclical sectors has declined since 2008. Financials, consumer goods, and technology now represent a significant share of the benchmark. 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 stocks to make it through the cyclical bumps
Overall, we believe the sell-off in EM equities may have been overdone but the ongoing geopolitical risks, the possibility of higher rates in developed markets and the recent slowdown in economic activity could continue to be a headwind for EM equities at an aggregate level. Therefore, we believe that long-term investors seeing buying opportunities in EM should use fundamental screening to reduce the risk of falling into a ‘yield trap’.
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. This is highlighted in the relative performance between the MSCI Emerging Market Index, and the MSCI EM Select Quality Yield (SQY) Index, which focuses on three criteria: profitability, leverage and earnings’ quality, before selecting the top 50% companies exhibiting the highest dividend yield. Typically, the quality screen provides greater defensive characteristics in periods of bear markets, such as during the commodity crash in 2014 and 2015.
 Based on Purchasing Power Parity (PPP) weights which are individual countries’ share of total World GDP at purchasing power parities. PPP theory relates changes in the nominal exchange rate between two countries’ currencies to changes in the countries’ price levels.