Key takeaways

  • EM fundamentals remain intact, but expect more volatility as markets digest interest rate changes and trade tensions.
  • Overall, another year of double-digit growth is forecast for corporate profits.
  • Rising U.S. interest rates may not be detrimental for emerging markets.
  • Asset class is becoming less correlated with commodities with growth in technology and consumer-related sectors.

Emerging markets are facing some challenges after a strong two-year rally: Global trade tensions, political election uncertainty in Latin American countries and a strengthening U.S. dollar have all contributed to the 7% decline year to date (as of July 6) for the MSCI Emerging Markets (EM) Index.

Is volatility here to stay? Will tighter U.S. monetary policy derail EM equities? How important is China to the asset class? This article tackles these pertinent issues.    

1. How should current volatility in emerging markets be viewed?

With trade disputes dominating headlines and both U.S. and China in the late stages of an economic cycle, some volatility is to be expected. That said, the emerging markets comprise a wide set of economies that are at different stages of the economic cycle. Longer term trends such as the growth of mobile commerce, an expanding consumer class and increasing smartphone usage look sustainable.

More importantly, earnings are growing for a wide swath of companies, and prices for oil and certain industrial metals should help export-led nations.

2018 Midyear Outlook

What are the insights and actions to consider as you position investment portfolios for the rest of the year?

“Corporate profits in emerging markets are growing, cash flows are improving and debt levels are decreasing. While I anticipate volatility to remain heightened in the near term, especially with Brazil’s presidential elections in October and uncertain resolutions of trade disputes, I don’t see a major crisis brewing of the magnitude that’s hurt emerging markets historically,” says portfolio manager Shaw Wagener, who’s invested in the asset class for nearly three decades.

Importantly, the maturation of economies within the developing world has changed the composition of earnings within emerging markets, making this diverse group less tied to highly cyclical industries.

“We are seeing domestic consumption, health care and leisure playing a more prominent role, particularly in China and other Asian countries that dominate the MSCI Emerging Markets Index,” Wagener explains. “Given China’s 30% weighting in the index, we would have to see signs of a major economic slowdown in China for the broader emerging markets universe to be affected significantly.”

2. What impact will higher U.S. interest rates have on emerging markets?

The U.S. Federal Reserve has hiked rates twice in 2018 and is signaling a total of four hikes for this calendar year. Does this automatically mean emerging markets will be negatively impacted?

Not necessarily.

There have been four previous monetary-tightening cycles since 1988. In three of those cycles, returns in emerging markets were positive on an annualized basis over those periods of rising rates in the U.S. 

“The recent rise in U.S. interest rates and Treasury yields has had a negative impact on several emerging markets. But I don’t anticipate that modest rate hikes by the Federal Reserve will have a dramatic effect on the economic situation in emerging markets,” says portfolio manager Chapman Taylor.

“As long as we continue to see stronger global growth, it should be supportive of emerging markets at a macro level. Furthermore, many emerging markets are fundamentally stronger than five years ago and have a long history of dealing with much higher interest rates and inflation,” Taylor says. “In this latest bout of volatility, the markets to some extent have differentiated between countries where fundamentals have improved and those where they have not. The entire asset class has not sold off indiscriminately.”

3. Are emerging markets still closely tied to movements in the commodities sector?

The correlation between emerging markets and commodities markets is less significant than it used to be. The representation of technology companies in the MSCI EM Index has grown significantly, fueled by technological advancements in the developing world. The information technology sector is the largest weighting in the index — by itself bigger than the materials, energy and industrials sectors combined.

“The rapid adoption of mobile devices and internet-connected automobiles and homes is driving consumption, creating data, and will develop more opportunities in emerging markets, especially in China and India,” says investment specialist Kent Chan. “Consumers in developing countries are surpassing their developed-market counterparts when it comes to the growth of e-commerce purchases, fintech and use of other online services. I would expect that trend to only grow.”

Correlations have loosened between emerging markets and commodities. This shift has coincided with the massive growth of technology companies, particularly Chinese internet giants Tencent and Alibaba, currently the two largest companies in the MSCI EM Index.

4. How important is the China factor?

China’s influence on the global economy and the emerging markets cannot be underestimated. The country is entering the late stages of an economic cycle, and the ongoing global trade tensions could contribute to the deceleration. “There is little doubt that China’s growth is gradually slowing, and I think we will see more evidence of this over the next six months. Authorities are tightening credit in housing and infrastructure and that is having an impact,” says economist Stephen Green.

Even so, the size of the economy and markets means there will always be areas of opportunity. Although the China technology sector has seen a huge run-up and could be vulnerable to a pullback, health care is a promising area. It is a strategic area of investment for the Chinese government, which wants to develop so-called national champions that could rival multinational health care companies.

Supportive government policies are aimed at fueling innovation in the health care sector, including generous R&D grants, tax-free laboratories and regulations to speed up the approval process for new drugs and medical devices. This development may be beneficial for companies such as Shanghai Pharmaceutical or Jiangsu Hengrui Medicine, two of the largest drug makers in China.