EM , We prefer equity for this quarter

For example, some argue that a tightening Fed is the root cause, others that China clamping down on credit growth has been an important driver of the global slowdown, and still others that EM has suffered from a string of idiosyncratic events that, when added together, have moved the broader asset class.

The recent bout of volatility and potential response of EM central banks to defend currencies (such as the case of Indonesia) add further downside risks to growth, and in this piece we assess how much of a growth slowdown has been priced in EM and where we see relative value. In short, we maintain our preference for EM equity over FX and fixed income (particularly credit which has Frontier market exposure), and still see EPS upside for Latin American equities in particular.

 Markets appear to have priced in additional weakening in EM growth

Running a similar analysis at the country level suggests that EM assets have been hit hardest in the markets where growth has slowed the most . Over the course of 2018, trade war concerns have likely pushed China, Taiwan, and Korea’s asset markets further than growth data implies (they are all “below the line”) – and, unsurprisingly, we would expect to see a bounce in these markets should the headlines brighten on this political risk. The other notable underperformers (relative to growth data) are India, Brazil, and Chile, three markets we would consider “babies with the bathwater”, particularly in equity.

We also find that EM FX headwinds do not necessarily fully compromise the EM equity story. EM FX (as mentioned in Exhibit 1) has borne the brunt of the EM sell-off this year, and while this has created a strong headwind for USD returns of EM equities and local bonds, we find that local equity prices have a track record of “bucking the FX trend” for considerable periods of time. For example, while the daily correlations tend to remain high, the 2011-2015 period exhibited markedly different return profiles for EM FX and EM equity.

We believe this divergence was caused by a dichotomy in the “growth differential” vs. “growth level” story for EM over the period. The ‘tradable rallies’ in EM equities between 2011-2015 coincide with accelerations in EM activity, but the overall growth differential vs. DM growth continued to decline, with EM FX depreciating with it.

Lastly, as mentioned above, our preference within EM equity remains Latin America, where we see continued resiliency in EPS (in Brazil and Mexico in particular). Both these EMs face considerable political noise (Mexico with a new president starting in December and potential continued noise around NAFTA, and an election in Brazil in October), but the EPS growth trajectory has remained remarkably resilient. As we show below, almost all EMs saw significant positive EPS revisions in the first five months of the year, but Summer months have been more challenging, and both Brazil and Mexico have continued to be of the few EMs with significant positive EPS trajectories. We think this is due to a ‘low base’ in both equity markets (profit margins are still below 2010-2011 averages, for example), and that there is more room to run barring a significant domestic political shock.

For investors who remain concerned about EM contagion, we find the below framework useful for thinking about external vulnerabilities. As discussed above, “contagion” has likely weighed on EM assets already but here we assess the basic metrics that macro investors use to quickly gauge which EM may be “next on the chopping block”. Specifically, we look at the total of short term USD debt and the current account deficit less FX reserves as a share of GDP. This is one metric on which to gauge EMs, and the main take-away is that smaller economies (mostly Frontier) are quite different from the large EMs – suggesting that credit is more vulnerable than equity (from a compositional perspective).

The underperformance trajectory is quite similar over the course of the past 12 months and, in our view, further suggests that the weakening is in part due to fundamentals, as opposed to, for example, a liquidity argument. There are a number of EM credit investors who are worried about positioning, given a high amount of ‘cross-over’ investment (from DM investors). While these concerns may be real, we do not think they have been the primary driver of EM credit returns thus far – and that concerns over Frontier Markets in both credit and equity are warranted.EM credit has large Frontier Market exposure, and the fundamental vulnerabilities there have been increasing. For EM FX to ‘work’ we would likely need to see EM’s growth differential vs. the US improve, which is not easy to see in the very near-term. But equities have less funding vulnerabilities  can bound on a stabilization of EM growth and currently trade just 5% above their valuation trough of January 2016 relative to DM.