The underperformance of emerging market assets in the first half of 2018 was not a sizable deterioration in aggregate economic activity and a budding crisis. Rather, the volatile year for emerging market equities and bonds was the result of investors buying the rumors of the late-cycle U.S. fiscal stimulus and ever higher expectations for U.S. economic activity and earnings growth. Capital, as always, flows to where growth is strongest. Emerging markets suffered disproportionally as capital flowed to U.S. dollar assets.
Slower Growth for the United States
Judging where we are in the U.S. cycle is important for emerging markets. In our view, the U.S. economy is no longer accelerating, the result of tightening by the U.S. Federal Reserve (Fed), higher interest rates across the yield curve, and a persistently strong dollar. We believe U.S. economic growth will slow in the first half of 2019 and weaken towards the historical trend growth rate in the second half. As a result, the Fed is likely to back down from its tightening stance that would cause the dollar to stabilize in the near term and weaken over the intermediate term. For 2019, the upshot for emerging market assets is an environment where U.S. growth is slower but policy is better, the exact opposite of 2018.
EM “Green Shoots”
Emerging market policymakers, for their part, pursued prudent policy measures even as external pressures mounted. Inflation is not overshooting in most of the major emerging market countries, Turkey and Argentina notwithstanding, and current account deficits are generally contained—a primary reason why Turkey’s economic crisis didn’t extend to the rest of the emerging economies. Real yields for sovereign local currency bonds remain attractive.
There is a good case to be made that so-called “green shoots” will arise in the emerging markets in the beginning of 2019, driven by modest Chinese stimulus, and growth will have stabilized by the second half of the year. The strategy of Chinese policymakers, thus far, is to deprioritize deleveraging. In the past, credit growth has rebounded significantly when policymakers have lowered the required reserve ratio for major banks. Nonetheless, the stimulus should be viewed as more of a multi-pronged “drip strategy” than a “bazooka” as it was in 2015-2016. There is resistance from the Chinese government to respond with massive stimulus and jeopardize long-term domestic financial stability. However, fixed asset investment, while not reaccelerating massively, does appear to be stabilizing.
In short, do not expect stellar support for emerging market growth from China. Rather, expect China to stabilize in the second half of the year and for many other emerging economies to follow in kind. Before we get too optimistic, we acknowledge that this scenario will be very dependent on the restrained stimulus measures in China gaining traction and on a more-favorable trade environment between the United States and China. A further deterioration in U.S. and China trade relations, while not our base case, looms as a non-trivial risk to global growth and international assets.
Long-Term Growth, Plus Valuations
For long-term investors, emerging markets are likely to see greater economic growth over the decades to come, driven by population shifts, urbanization, and expanding consumption. These growth trends are likely to be meaningfully higher than they are for developed markets, which must contend with high debt levels and ageing populations.
The near-term case for emerging markets is even stronger, driven by valuations. There can be little question that from a valuation perspective, emerging market assets remain the most attractive, but there needs to be a catalyst for current circumstances to change.
Slowing U.S. growth, a Fed pause, stabilizing Chinese growth, and an easing of trade tensions could each or all be the catalyst(s). The U.S. fiscal deficit will be important. Regardless of which party has the most power in Washington, we don’t think either party is willing to risk the political backlash that will come from trying to reduce the fiscal deficit meaningfully. In that context, the U.S. fiscal deficit will continue to widen, and it will need to be funded by foreign buyers rather than domestic savings. This makes a lower dollar more likely.
Growth Will Come from Emerging Markets
Global investing is about growth. For long-term asset owners, the outlook for growth is meaningfully higher away from developed markets. Without meaningful changes to the structure of the U.S. economy, we think the long-term trend growth rate is going to be 2% at best, and even lower in Europe. As noted above, these changes are unlikely given the debt levels and demographics of developed markets. At the same time, global investing is about diversification. Countries move in and out of favor. A globally diversified portfolio should deliver higher returns with lower volatility—and that makes the case for having a portfolio that always remains diversified across both developed and developing markets.
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Our equity and fixed-income investments, who spend considerable time in these markets, share their insights on where they believe the greatest opportunities lie. Our Innovation Index also demonstrates emerging markets may lead the next wave of technological breakthroughs.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or as a prediction of the performance of any investment. These views are as of the open of business on December 3, 2018, and are subject to change on the basis of subsequent developments.
Equities are subject to market risk and volatility; they may gain or lose value. Fixed income investing entails credit and interest rate risks. Bonds are exposed to credit and interest rate risk. When interest rates rise, bond prices generally fall. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Emerging and developing markets may be especially volatile. The mention of specific countries, currencies, companies, or sectors does not constitute a recommendation by any particular fund or by OppenheimerFunds, Inc. Certain Oppenheimer funds may hold the securities of the companies mentioned. It should not be assumed that an investment in the securities identified was or will be profitable.