Regrettably, I got the call on emerging markets, at least for this year, wrong. At the beginning of the year, I reasoned that deficit-funded U.S. fiscal stimulus would ultimately leak to the rest of the world, as American consumers and businesses went on a global shopping spree. I anticipated a period like the episode following the 2003 Bush tax cuts, which resulted in ever-widening U.S. trade deficits, foreign reserves rising everywhere in the world, and boom times for emerging markets.

Alas, that has not played out as expected. What went wrong? Emerging markets are still viewed by many large investors as allocation decisions rather than strategic long-term positions. As a result, for emerging markets to perform well, not only do fundamentals need to be improving, but also capital needs to be flowing to the emerging economies. Both trends aligned in 2017, as most emerging markets benefited from 2016 Chinese stimulus and the ensuing commodity rally, and investor flows followed in kind. For 2017, the broad MSCI EM Index was up 37.9%.

Fundamentals Have Not Deteriorated

So far this year, aggregate emerging market fundamentals (including Chinese growth) have admittedly weakened a tad but not meaningfully. For most of the major emerging market economies, the leading economic indicators, such as the Manufacturing Purchasing Managers’ indices, remain in expansionary territory with countries such as India, Indonesia, and Vietnam signaling further strength. Turkey is the notable outlier.

Exhibit 1: Manufacturing Purchasing Managers

Additionally, in contrast with other periods of EM volatility, the global trade picture hasn’t deteriorated, commodity prices haven’t collapsed, and inflation hasn’t spiked.

Exhibit 2: CPB Merchandise World Trade Volume Index

It’s a Flows Story

Nonetheless, the flows story has turned around massively. To this, I assign three primary reasons:

  1. U.S. growth has accelerated, decoupling from the rest of the world.
  2. U.S. wages are rising and the U.S. Federal Reserve is proceeding on its tightening path.
  3. Idiosyncratic events in countries such as Turkey and Argentina are damaging sentiment.

The Trump administration’s trade actions and rhetoric have compounded the sentiment problem. The ultimate impact of tariffs on global growth will be small, but the “trade war” has served to highlight the growing dispersion of growth between the United States and the rest of the world. Capital will always flow to where growth is stronger.

Exhibit 3: Bloomberg EM Capital Flow Proxy Index

Unfortunately, getting the fundamentals story generally right and the flows story wrong is no better than getting both stories wrong, as is being attested by the 12% year-to-date price decline in the MSCI EM Index. The local bond indices haven’t fared much better. Investors are now left to grapple with whether the ongoing market correction will prove a buying opportunity in the style of early 2016 or whether a late 1990s currency crisis and contagion could be in the offing, or none of the above. For the short term, I choose the latter -- none of the above. There is little in the fundamentals to suggest a wide and systemic crisis is looming. Most emerging economies, again, Turkey notwithstanding, simply don’t have the balance of payment issues that they did in 1997.

Exhibit 4: Current Account Balance % of GDP: 2017 vs. 1997

But for flows to reverse and the market recovery to commence, the mere fact that emerging market valuations have improved is not enough. I believe there needs to be a catalyst to unlock that value in the market. Specifically, the growth differentials between the United States and the emerging markets would have to converge. This will not play out as it did in 2016 and 2017, with emerging market economies accelerating to above-trend levels of growth. China has already commenced stimulating their economy, but the level of stimulus won’t come close to that of two years ago.

Instead, the growth differentials would have to converge with the U.S. slowing down, a development that would get the Fed off its tightening stance. That will not be a 2018 happening. The risk is that if the U.S. capital expenditures  and/or wage growth story really gets going and produces higher, sustained levels of U.S. growth, then we are in for a prolonged period of dollar strength. All bets would be off for the emerging markets.

Fortunately, that is not my view. I expect that by 2019 the strong dollar, tighter Fed policy, the flattening yield curve, and less of a boost from government spending will slow the U.S. economy. Already, U.S. leading indicators (ISM PMI New Orders, Conference Board 10 Leading Economic Indicators) and coincident indicators (industrial production) are at levels where they often roll over, which is followed months later by slower growth. As I have said time and again, watch the U.S. dollar. Dollar weakness would indicate that U.S. growth is converging to that of the rest of the world.

Exhibit 5: Leading Indicators, Industrial Production, and New Orders

For now, I recognize the impact this has had on investors, and I am keeping my eyes on what compelled me to allocate money to emerging markets in the first place—they are potentially the world’s best prospect for long-term dynamic growth.