Beyond global trade risks and other demons

Towards the end of 2016, as a result of the US elections, emerging-market investor uncertainty increased. As we approach the end of the first quarter of 2017, it’s time to take a look at developments in emerging markets and what investors should bear in mind for the months to come.

Beyond the risks concerning negative trade policies, political uncertainty and economic protectionism from the US, there are three main reasons why we are still optimistic for the prospects of emerging markets:

1. Positive macroeconomic and earnings picture: We believe that fundamental data, as well as the macro situation in the underlying economies, is improving. Brazil and Russia are recovering, with higher commodity prices helping them (as well as other commodity exporting economies) to recover. Brazil and Russia are also important trading partners for China, so they will be buying more Chinese products compared to last year and the year before. The outlook on China is also stabilising; people are now less fearful of a strong devaluation of the renminbi. At the same time, gross domestic products (GDP) growth is stabilising and nominal GDP is improving as the Producer Price Index (PPI) has turned positive. This should lead to an advancement in earnings growth which – combined with more disciplined capital expenditure – should develop into a higher return on invested capital for companies. All these factors should ultimately result in a rerating of the stock market.
2. The market overestimates the risk of a stronger US dollar: In the past, there was a negative correlation between the US dollar and the performance of emerging-market stocks; we believe that this relationship will weaken. Historically, the US dollar has been the source for funding global liquidity. However, other currencies have grown in importance, for example, China is promoting the renminbi as a global currency and is providing liquidity. Emerging-markets countries are becoming less dependent on US dollar funding. Major economies, like South Korea and China, are running large current account surpluses and countries which previously had substantial current accounts deficits, have reduced or even turned them into surpluses. Moreover, the composition of the MSCI Emerging Markets Index has shifted from US dollar sensitive sectors like energy and materials to sectors which are more domestically driven like the internet. For example, companies like Largan Precision or Taiwan Semiconductor, which have their costs in local currency but sell their products in US dollars, should definitely profit from a strong US dollar.
3. Valuation: Valuation of emerging-market equities are still compelling, companies from emerging markets offer a higher growth rate compared to their global peers, while they are still trading at a discount to global equities. At the same time, earnings revisions are improving strongly, which should be another performance driver.

For the remainder of the year, we favour high-quality companies which are trading at a discount to their fair value and their peers. We like domestic companies which would not be directly impacted by negative trade policies. We are also positioned in global leading companies such as Largan Precision and Taiwan Semiconductor, which are leading because they have superior technology and intellectual property compared to their competitors and if needed, they would have the capabilities to shift production to the US.

Thomas Schaffner – Vontobel Asset Management