Should you be investing in emerging markets?

Rising US rates and tightening US dollar liquidity are causing stress in some emerging markets. This has been the main impetus behind a recent outflow of funds from these markets as investors have become more cautious. For Australians, is investing in emerging market assets advisable for a diversified portfolio?

In our view, there are three factors that are likely to impact emerging markets in the near term

  1. US rate rises and tightening liquidity leading to US dollar strength against most currencies
  2. oil price strength in US dollars and especially in local currency terms
  3. geopolitical uncertainty, in particular ‘trade wars’, which seem likely to disproportionately affect some emerging market exporting countries

US dollar strength is the most obvious and immediate factor, however, we note that significant weakness in emerging market currencies is mostly limited to Argentina, Brazil, Turkey and South Africa (to an extent). A number of important countries under the ‘emerging markets’ banner are in better positions financially than in previous cycles and therefore a broad ‘contagion’ is, in our view, unlikely.

Growth overall remains solid, particularly in the Asian region

Morgan Stanley estimates 2018 and 2019 growth for Asia to be about five per cent. Key Asian markets are also running current account surpluses, limiting the effect of higher US rates and tighter liquidity. Accordingly, Asian markets remain a key exposure for our investments.

Risks do remain. As US rates continue to rise, local currencies will come under pressure. Local central banks may feel forced into raising their own benchmark rates to combat currency weakness and increasing inflation, thus dampening growth in these economies. Debt levels for some emerging markets have grown in recent years and rising rates will make it harder for countries with large US dollar denominated balances to service and repay that debt.

Rising oil prices are already affecting energy importers in weak financial positions such as Argentina, Turkey and South Africa. The rise will also likely act as a drag on growth in other big energy importers such as India and China.

A looming US trade war is not expected to be helpful

The US economy will also likely not benefit. In our view, a trade war is likely to act as a drag on growth for exporting economies. In 2015, to positive effect, China injected significant monetary stimulus to combat a world slowdown. We believe that China’s ability to do so in the event of continuing trade uncertainty is more limited today given higher debt levels, overcapacity and pollution issues. The emerging markets (and indeed Australia) are less likely to be rescued by China this cycle.

Over the longer term, the positive macro story in key emerging markets remains intact

We believe the differences are often greater than the similarities between countries under the broad emerging markets umbrella and it is important to be selective in choosing exposure. However, overall we expect markets to remain volatile for a period, and for certain countries to struggle as US rates continue to rise. Geopolitical uncertainty and higher oil prices will also affect investor sentiment – therefore, in the short-to-medium term we are cautious, but remain positive about the longer-term demographic and economic drivers.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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Patrick Broughton

Investment Committee Member

Patrick has 32 years of investment banking experience spanning over a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange.

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