Investors in emerging market equities have to be prepared to muddle through in the coming months as the asset class is beset by potentially more interest rate cuts by the US Federal Reserve (Fed) and a strong US dollar.
More interest rate cuts from the Fed are expected as the US grapples with a potential recession that may result from the US-China trade war, Brexit, and other geopolitical uncertainties plaguing the global markets.
“The trends that are driving the asset class are the US dollar and the impact of the Federal Reserve rate cuts. A strong dollar is not good for emerging markets because when the dollar is strong, people don’t want to take the risk of investing in emerging markets when they have good returns in the US. The dollar is above its long term averages,” says Emily Whiting, executive director, emerging markets and Asia-Pacific equities team at J.P. Morgan Asset Management.
In an interview with The Asset, Whiting says the US Fed and the US dollar are driving emerging market equities at this time. Other central banks in developed markets and emerging markets are also expected to cut interest rates in the coming months.
“The benefit for emerging markets is that their central banks have more room to maneuver because their rates are higher than in the US and the ECB (European Central Bank) where interest rates are negative. The way we see things is we’re in very much a muddle-through situation,” Whiting says.
“What we mean by that is it’s a tug of war between the slowing economic growth which is everywhere and the central banks who are trying to give liquidity and quantitative easing to the market. Now how long that lasts, there’s no timeframe. Where you go to next depends on who wins. Does the growth pick up and PMI (purchasing managers index) numbers start to turn aided by the central bank, or does slowing growth given the potential recession and trade war tensions in the US win out?,” Whiting says.
A number of emerging market central banks have cut interest rates in the past few months as part of their quantitative easing monetary policy. These include Russia, South Africa, Brazil, and Thailand.
The exception is China where the chief of the People’s Bank of China, Yi Gang, said last week that the Chinese economic condition is in a “reasonable range” which means that there is no need for major interest rate cuts. The PBOC has, however, cut the reserve ratio requirement three times this year and economic growth has continued to slow down.
“Clearly China hasn’t done so yet but they have that firepower behind them. So you’re almost in this uncertain situation,” Whiting says.
However, what makes emerging market equities attractive as an investment opportunity is that valuations are below the long term average which means they are relatively cheap at this time.
“Valuations are below their long term averages. So if we take the average price to book valuation in emerging markets as 1.8%, valuation right now is about 1.5-1.6%. So a lot of that bad news is priced in. Emerging markets are saying ‘it’s fairly cheap because of all these uncertainties so don’t ignore us’. But I think what you need to do is be selective not just by market but also by the types of companies you want to invest in,” Whiting says.
“So 2019 looks like a lost year in some ways for equities but for emerging markets, valuations that you’re paying for compensates you for the fact that there have been all these uncertainties," she continues.
Although a potential US recession is expected to negatively impact emerging markets, emerging market equities may still provide good investment opportunities.
“It would be naïve to say that anyone is immune to a US recession. However, because a lot of the heat has already been taken out and valuations are already on the cheaper side, as much as it will be pulled down, it will bounce back quicker. And we’ve seen that historically. It’s similar to what happened in 2002. Emerging market equities will be pulled down but because valuations have been reflective of where we are, it will bounce back quicker,” Whiting says.