Beyond the US Mid-Term Elections: Emerging Markets Look to Turn the Corner

Now that the US mid-term elections are behind us, it is a good time to reflect on the potential implications for an asset class that might not spring to mind: emerging markets equity. To appreciate the effect of the US elections on emerging markets, it is necessary to take a step back and review the issues affecting the asset class. On the back of surging earnings and global synchronized economic growth, emerging markets soared in 2017, with the MSCI Emerging Markets Index (USD) up 37%  in a market driven by growth and momentum. The euphoric highs of 2017 faded relatively quickly, as a variety of macroeconomic events and adverse headline news created a distinct headwind for emerging markets equities, which are now down more than 12% year to date. We believe that several factors will be vital for emerging markets to turn the corner and get out of the doldrums.

The champagne-induced hangovers had barely subsided in 2018 when the global synchronized economic growth story that helped lift markets around the world disintegrated. Data indicated that the European economy was decelerating, which negatively affected non-US equity markets. Despite positive economic data in the US, which normally bolsters emerging markets, the Federal Reserve (the Fed) has moved to normalize monetary policy by increasing rates to head off the potential of an overheated economy. The US dollar strengthened as a result, which adversely affected emerging markets currencies, particularly in countries with a negative current account balance. Given the economic momentum in the US, it is likely that the Fed will continue to tighten monetary policy in the near term. That being said, the Fed policy futures market indicates that in mid-2019, rate hikes are expected to slow, which undoubtedly can help ease the pressure on emerging markets.

The larger cloud hanging over emerging markets equity is the escalating trade conflict between the world’s two largest economies: the US and China. In a sequence of tit-for-tat announcements, the two nations have introduced a series of escalating tariffs on a wide range of goods. The trade spat has effectively dampened the mood of emerging markets participants as they try to decipher the implications of a broader trade war involving China—the most important of the emerging markets. Many portfolio managers feel that after losing the House of Representatives, President Trump, after applying heavy pressure on China to change its trade practices, will take a more conciliatory approach and ultimately strike a deal, as he did in renegotiating NAFTA (now known as the US-Mexico-Canada Agreement or “USMCA”). Alternatively, some portfolio managers believe that given the resistance the President’s legislative agenda will face from the opposition party now in power in the House, he will seek trade policy that does not require legislative approval to make sweeping changes. Either way, it seems the issue of trade policy with China will come to a head later this month when President Trump and President Xi Jinping of China meet to hammer out an agreement. If the two sides can come to an acceptable agreement, the broader emerging markets space will no longer be threatened by a trade war.

There is no doubt that emerging markets have faced a variety of headwinds so far in 2018. Although their economies continue to develop, market reforms continue apace, and earnings remain strong, significant macroeconomic and headline issues have distracted market participants from good news in the asset class. With the mid-term elections in the rear view mirror and a potential thawing of trade relations between the US and China on the horizon, there is hope that emerging markets will move past their recent difficulties.

Dan Homan, CFA