trade wars and emerging markets.

global perspectives

trade wars and emerging markets.

28. November 2018

Salman Ahmed, PhD

Chief Investment Strategist

Didier Rabattu

CIO, Sustainability Equities

Understanding the drivers of the current trade war remains key to understanding current and future asset market developments, especially in emerging markets (EM).

There are two key points which we feel are important and will be important in terms of shaping the dynamics in 2019. Valuations are looking quite attractive and the pricing of the damage, especially coming from the trade war, looks too extreme in our view. Coupled with the fact that we expect the dollar to peak in early 2019 we think there is a strong likelihood that EMs are going to rebound in going forward in the next 12 months.

As discussed in our earlier note, ‘battered EM set for a rebound?,’ we think the growth damage priced into EM equity markets is out-of-sync with what the confrontation between US and China actually entails (under reasonable assumptions). This implies the severe decoupling we have witnessed this year between US and EM assets has scope to reverse in coming months as the catalysts necessary for such a reversal start to assert themselves.

There are several reasons behind that decoupling. First amongst them is the US/China trade war. A stronger Dollar led by a Federal Reserve hiking cycle have also added further pressure. All these factors we think will change in 2019 to a certain extent. We expect the Fed to hike at a much gradual pace. We expect the dollar to peak in 2019, and some rapprochement between US and China to come to the fore, which will help the fundamentals reassert themselves.

We think Chinese equities’ peak-to-trough fall reflects a growth hit of +1 percentage point (ppt), whilst the stimulus measures being planned may add 0.5 to 0.6ppt to growth next year. The broader stability of China and its currency are also likely to be an important positive tail wind for other EM countries, especially as countries prone to idiosyncratic risks – like Turkey and Argentina – show signs of stabilization following recent policy actions.

According to our estimates, the dividend yield differential between EM and DM equities – currently around 0.4% – is now similar to levels seen in September/October 2015 in the immediate aftermath of the yuan shock. In our view, this prices in a significant amount of stress. Similarly, price-to-book differentials are as extreme as they were in late 2015/early 2016, despite stronger growth and external fundamentals in a number of emerging markets. EM growth revisions are likely to turn positive in the coming months - led by China – and we think this discount will need to be reassessed by the market, and could potentially lead to a rebound going into year-end.

So for 2019 we expect EM assets to rebound. 2018 was actually a year where EM assets completely decoupled from world market assets, and underperformed significantly. It’s one of those rare instances we see over the last 17 years that such kind of decoupling has happened.

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