Dollar Headwind to Emerging Markets Equities Lifting, Though Trade Dispute Still Drags


June 11, 2019 [China, trade conflict, emerging markets]

After a turbulent May, China and emerging markets appear poised to resume their ascent from the first quarter, even as trade-related air pockets remain likely.

The spring exodus of investors from emerging market equities has spilled over into summer, as the U.S.-China trade conflict intensified and U.S. President Donald Trump briefly threatened to wield his tariff stick against Mexico. Investor anxiety is understandable, as “the trade friction undercuts growth in world trade volumes and delays investment decisions,” says Thornburg portfolio manager Charlie Wilson. “And that, in turn, compounds concerns about ebbing global economic growth.”

But those fleeing developing country assets would do well to consider the signals coming from monetary authorities in the U.S., China and elsewhere. Moreover, on both valuation and political risk metrics in a number of major emerging markets, the asset class remains compelling.

The Trump administration’s threats to raise the tariffs already in place on Chinese exports to the U.S., along with the short-lived warning of new taxes on imports from Mexico if it doesn’t do more to control undocumented migrants heading for its border with the U.S., has shaken investors. In May $7.4 billion flowed out of Chinese equities and another $7.2 billion exited other emerging market stocks, making for the biggest monthly outflow since June 2013, according to the Institute of International Finance. Meanwhile, Bank of America Merrill Lynch reports that in the week to June 5, another $2.1 billion fled emerging market equities funds.

Wilson, who runs strategies focused on emerging markets, and fellow Thornburg portfolio manager Lei Wang, whose strategies are international and can include developing countries, just returned from separate visits with numerous corporate executives in China. In addition to updates on current portfolio holdings and deep dives into prospective investments, they were able to survey the effectiveness of Beijing’s stimulus efforts, which Wilson had detailed in his December whitepaper, and take the temperature of business and consumer sentiment in the world’s second-largest economy. In this Q&A, they discuss the various headwinds and tailwinds that Chinese companies are navigating, and those best positioned to perform through the political and macroeconomic cross-currents.

Q: The MSCI Emerging Markets Index and the MSCI China Index surged 12% and 21%, respectively, over the first four months of this year, only to fall 7.2% and 13% in May. What happened?

CW: Both the trade dispute and U.S. monetary policy have been whipsawing Chinese, and for that matter, global equities for some time. Remember that in the first half of 2018, global stocks were mostly treading water. But around a year ago, Trump began upping the ante in the trade fight with China, causing Chinese and other emerging markets stocks to start sinking. The U.S. Federal Reserve, meanwhile, had continued to raise interest rates and shrink its balance sheet, and by last fall, developed world stocks started selling off as well.

By early January, Fed Chairman Jerome Powell effectively made clear the Fed would pause its hiking cycle and also suggested its balance sheet contraction wasn’t on “autopilot.” It also seemed that a resolution of the U.S.-China trade conflict was near, lifting sentiment and risk assets globally. That reversed in May, when the trade negotiations broke down and U.S. economic data started showing signs of weakness. The May labor market report came in much weaker than forecast, driving up market expectations that the Fed would cut rates at least once this year. Dovish comments from a handful of Fed officials also boosted hopes that U.S. monetary easing is on the way, which explains the pop in risk assets earlier this month. A more accommodative Fed reduces the dollar headwind that tends to mask strong emerging market earnings in local currency terms and allows developing country central banks to gradually ease their own monetary policies amid generally tepid inflation.

Q: Doesn’t the trade dispute continue to weigh on Chinese risk assets?

LW: It does. That’s why it makes sense to invest more in companies focused on the Chinese consumer, whose income has been rising steadily for many years. Beijing’s efforts to rebalance the economy away from investment toward domestic consumption have advanced significantly. Consumption now accounts for roughly two-thirds of China’s economy, while gross capital formation amounts to about 12% and trade about a fifth. In fact, the contribution of net trade to China’s GDP growth has been close to zero for several years now.

There are also the stimulus efforts. China’s central bank has eased policy on a number of fronts, from interest rates to lower bank reserve requirements. And the government has also lowered taxes, corporate pension contributions and introduced more export rebates for companies affected by the trade dispute. Still, investments focused on the Chinese consumer should prove more resilient to trade disruptions. Forward earnings estimates on many of them reflect double-digit earnings growth in dollar terms, and valuations aren’t overly demanding. But as Chinese stocks have had a good run overall it’s important to be selective and pick your shots carefully. The rally earlier this year was helpful, but so was the retreat in May, given the opportunities to get back into select stocks at better price points. We’ve trimmed our portfolio weighting to China, but still have meaningful exposure to Chinese stocks.

CW: Chinese growth stocks had a particularly strong run from their valuation lows late last year to April, so it made sense to take some profit early in the second quarter and add a little back during the selloff in May. But with the dollar overhang starting to lift, we’ve found attractive opportunities in several other major emerging markets. Elections in India and Indonesia both resulted in the reelection of market-friendly reformers, and in the case of Indian Prime Minister Narendra Modi, his allies sharply expanded their representation in parliament, which should really boost the reform agenda, particularly labor market, land reform for infrastructure development and deregulation. Brazil’s also trying to advance needed pension reform, and valuations in all three countries are attractive relative to past levels.

That’s especially true now that the dollar strength of the last few years looks likely to lift with the Fed making more accommodative noises and Fed funds futures pricing in a couple rate cuts before year end. And that’s given cover for central banks in India, the Philippines, Australia and New Zealand to cut their benchmark rates.

LW: I’d add that the European Central Bank also appears to be postponing its tightening plans, while the Bank of England is now in dovish mode on the latest Brexit-related issues.

Q: Still, couldn’t the U.S.-China trade dispute undercut the increasingly favorable monetary backdrop? Or do you expect a resolution sometime soon?

CW: I think it’s unlikely to be resolved near term. The trade dispute has morphed, it seems, into something involving more than trade, to include national security and impede Chinese investments and tech equipment sales abroad. So if last year Chinese citizens were wary of President Xi Jinping’s push to protect the Communist party, favor state-owned companies and extend his time in office, this year they view Trump’s China agenda as a bald effort to simply keep China down. That perception alone isn’t helpful. On the flip side, there may be a misperception of how vulnerable China is to tariffs on its goods sales to the U.S. Only about a quarter of the roughly $540 billion in goods exports to the U.S. last year were actually made in China; three-quarters involved partial or final assembly. So the impact of tariffs isn’t as great as it seems. Also, China’s potential GDP growth is running around 4.3% and the Li Keqiang Index of hard economic activity is around 8.7%, indicating Beijing’s stimulus is kicking in and there’s room to run. On the other hand, the U.S. output gap has closed, as the long recovery may now be slowing, as the latest jobs data, not to mention Composite PMIs (Purchasing Managers Index), suggest.

LW: It’s true that Xi has more domestic popular support than he did a year ago. It’s also true that many Chinese executives want a resolution to the trade issues, and believe China is at a point where it can compete with foreign companies looking to invest in China and in third countries, and do it without forced technology transfers or infringement on intellectual property. China has about as many patent applications as the U.S., and may have more in a couple years given its advances in tech developments. Nor do China’s private companies want Beijing to favor state-owned companies. Many of the U.S.’s demands are reasonable, but the approach isn’t improving the odds of striking a deal. If a deal is reached, though, it would create a major boost to markets in China, the U.S. and globally. In the meantime, strong earnings growth and reasonable valuations among quality, domestically focused Chinese companies can make the wait for a resolution much nicer.

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