Q&A: Idiosyncratic issues mask—and create—opportunities in the EM

10-02-2018

Given potentially destabilizing trade wars and dollar strength, we asked Client Portfolio Manager Peter Smith to share the Federated equity team’s views on the emerging-market asset class.

Q: What is the investment outlook for EM equities? We remain cautious as the stronger dollar, trade tensions and individual geopolitical events clearly have weighed on EM returns. But we do not see contagion, i.e., these issues spreading through all of the EM asset class. The problems tend to be isolated within individual countries, including Venezuela (massive inflation), Turkey (plunging currency and economic challenges) and Argentina (corruption and shaky government policies). In the meantime, India is experiencing robust growth in spite of internal political turmoil, Brazil continues to turn the corner and Southeast Asian economies look strong. Our biggest concern is dollar strength, which puts pressure on all EM economies given the growth of their debt levels. If the cost to service dollar-denominated debt goes up, then pressure will build. On the other hand, EM earnings expectations for the rest of this year and 2019 remain strong, with valuations at or below their 20-year averages.

Q: What about China? Despite its mounting trade war with the U.S., China’s economy continues to grow at or above consensus—6.7% annualized in the second quarter, with 6%-plus GDP growth expected in the second half. Manufacturing and service PMIs keep signaling expansion, although they have softened as U.S. tariffs have started to hit—China Beige Book reports manufacturers are starting to see declining revenues and sharply declining profit growth. Business and consumer sentiment remains positive, while the “Made in China 2025” initiative aimed at making the country dominant in global high-tech manufacturing has investments in services and technology on the rise. Recent auto sales data indicate consumer spending also remains firm. Looming over all this, of course, is the trade war. China has canceled—for now—future trade talks with the U.S. as it awaits the outcome of November’s midterm elections. Clearly, the trade tensions aren’t likely to end anytime soon and almost assuredly will have an impact beyond just the economic front. For example, we think as long as there’s a trade fight, China will work to disrupt U.S. negotiations with North Korea.

Q: Where are the opportunities in the EM? Abetted by high uncertainty levels and low investor sentiment, the EM space appears ripe for active management, with investment opportunities arising on a selective basis. We are looking for attractively priced companies with competitive advantages and strong growth profiles. We have found some in South Africa and China, and think further opportunity exists in India and Southeast Asian countries that manufacture many of the components that go into the growing technology sector. These economies continue to grow from both internal demand and exports. India is a good example. Its economy is expanding at an above 8% rate, export demand is growing and sentiment is high. So to reiterate, because we think contagion is unlikely to spread throughout the EM, we are using this downturn to selectively seek out prospective investments.

Thank you, Peter.