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EM Strategy Views Summary

Core Content

This document outlines the current state and outlook for Emerging Market (EM) assets, emphasizing the preference for equity over FX and credit in the current market environment. The analysis covers EM volatility, growth dynamics, valuation levels, and the impact of external and internal factors on EM performance.

Main Views

1. EM Volatility and Underperformance

• EM assets have experienced significant volatility and underperformance this year, continuing a trend that started as a broader non-US sell-off but has now become more EM-specific.
• EM FX has been the hardest hit, despite relative stability in Developed Market (DM) currencies like EUR, GBP, and JPY.
• The underperformance is attributed to a combination of contagion effects, technical factors, and weaker growth.
• The "sell in May" adage has been particularly relevant this year, highlighting a seasonal weakness in EM assets.

2. Growth Dynamics as the Primary Driver

• EM underperformance is primarily driven by softer growth, with global headwinds expected to reduce EM growth by 1-1.5 percentage points in 2018.
• Domestic financial tightening further pressures growth, though the market has already priced in a 2 percentage point slowdown in EM growth.
• Political risks and external shocks (e.g., trade wars, Fed tightening) continue to pose downside risks to growth.

3. Preference for EM Equity

• The authors prefer equity exposure over FX and credit, citing:
  • Less funding vulnerability compared to credit and FX.
  • Potential for upside if EM growth stabilizes.
  • Current valuations are at a 5% premium to their 2016 trough, suggesting a floor level for EM equities.
• EM equity is mostly composed of Asian markets, which are relatively resilient and have shown potential for improvement despite the trade war narrative.
• The 2011-2015 period demonstrated that EM equities can outperform even in FX weakness, highlighting their resilience.

4. EM Credit Vulnerabilities

• EM credit, particularly Frontier Market debt, has underperformed due to fundamental weaknesses.
• The underperformance is more a credit issue than an equity one, with EM credit being more vulnerable to external shocks and domestic financial tightening.
• Political instability and external financing needs are key factors affecting credit performance.

5. Country-Level Analysis and Valuation

• EM equity valuation and earnings growth remain relatively attractive, especially in Latin America.
• Markets like Brazil and Mexico have shown resilience in EPS growth despite political uncertainties.
• Malaysia, Chile, and India are highlighted as having underperformed relative to growth data, indicating potential for recovery.
• Turkey and Argentina are considered the most vulnerable due to their high external funding needs and high FX exposure.

Key Information

• EM FX has underperformed due to contagion effects and external headwinds, but is not the only driver.
• EM equity has shown resilience and room for recovery, especially in the context of stabilized growth and low valuations.
• Frontier Markets are more susceptible to credit risks and liquidity pressures, which have been exacerbated by external shocks and domestic policy changes.
• The growth differential between EM and DM is a critical factor in EM asset performance.
• Valuation metrics suggest EM equities are undervalued, with a 5% premium to their 2016 trough.
• The recent volatility in EM markets has not fully priced in the growth slowdown, creating a potential buying opportunity for equities.

Relative Value and Outlook

• EM equities have room to run in terms of earnings and valuations.
• The authors maintain a long EM equity position, particularly in Latin America, despite short-term volatility.
• EM FX and credit are less attractive due to higher risk and less room for recovery.
• The medium-term outlook for EM equities is positive, with a focus on growth stabilization and valuation recovery.

Conclusion

• EM assets continue to face volatility and underperformance, but the primary driver is growth weakness, not liquidity.
• Equity is the preferred asset class for EM exposure due to its resilience, lower funding risk, and attractive valuations.
• Frontier Markets are particularly vulnerable, especially in terms of credit and external financing.
• Latin American equities, particularly Brazil and Mexico, are highlighted as relative value opportunities due to resilient earnings and political stability.