Investment Strategy:  First Quarter – Specific Market Reviews: Emerging Markets and Asia

  • The emerging markets are caught in the cross-hairs. Higher US interest rates and a stronger dollar have tightened liquidity and pushed up borrowing costs as well as sucking capital away from the area putting pressure on EM exchange rates precipitating crises in Turkey and Argentina. To add to their woes, a slowdown in China is a very strong headwind for pretty much all emerging markets, as is Trump’s trade war.
  • There is clear evidence of slowing growth in China with the manufacturing PMI falling to 50, the point that separates contraction from expansion, for the first time since July 2016. Car sales look set to record their first annual decline since the 1990s and retail sales in general are growing at their slowest pace since 2003. The authorities are trying to achieve a gradual and controlled slowdown to gently deflate the credit bubble and tackle the huge shadow banking network (the non-Bank sources of credit) but don’t want too sharp a contraction. Given its importance to the world economy and as the target of Trump’s trade wars, global investors will be paying increasingly nervous attention to China this year.
  • The MSCI Emerging Market index tumbled by 10% last year. There remains though a wide diversity of return between the individual markets which shouldn’t be viewed as a homogenous bloc. Russia and Brazil were both up 16% in local terms (though both returned only 5% when translated back into sterling due to the weakness of their currencies), India eked out a small gain whereas China and Korea were down nearly 20%.
  • In the Q4 newsletter I noted that the Topix Index was bang on the 1800 ‘iron coffin’, the level the index has failed to breach on numerous occasions since 1989. Yet again the coffin lid held and the index has tumbled back to 1500, though this was due to the generalised fall in global markets rather than anything Japan specific. Fundamentals remain in place for a decent run in stock prices unless global considerations get in the way again. The economy is healthier than for many years with the three decades of deflation finally at an end. Decent earnings growth, improving profit margins, structural reforms, a stable and supportive political and monetary environment, much improved corporate governance and an increasing flow of both domestic and foreign money into the stock market are all tailwinds. The market P/E is 12x, relatively inexpensive by global standards and extremely cheap historically for Japan, with a dividend yield of 2.4% which is a sea change from the previous experience of companies hoarding huge cash piles.
  • As with Japan, so too with the Emerging Markets. The news flow was unremittingly bleak last year but the market valuation has fallen significantly as share prices tumbled. The MSCI EM Index is now trading on a forward P/E of around 10.5x and if the global environment improves then the EMs should be amongst the biggest gainers.

Summary: Emerging and Asian Markets fell heavily last year in the face of strong external headwinds; tighter US monetary policy, a strengthening US dollar and the trade war between Trump and China. A sense that US monetary policy is now close to neutral should be a positive this year, as would any improvement in trade tensions. These markets remain best suited to higher risk/reward investors with a long-term time horizon and acceptance of a high level of volatility.

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