Capital Ideas^™ 
Investment insights from Capital Group

Emerging markets have hit a rough patch, with the benchmark MSCI Emerging Markets Index declining roughly 16% since hitting a two-year high on Jan. 26. The pullback is not a surprise, given the substantial 93% gain over a two-year period that stretched from January 2016 to January 2018.

Political uncertainty and economic turmoil in Brazil, Turkey and Argentina, which are large borrowers in international financial markets, have dragged markets lower at times. On the positive side, corporate profitability continues to be solid, especially for new economy companies in the technology and consumer discretionary segments. Nevertheless, volatility likely will continue as markets search for a new equilibrium. 

Emerging markets: Old vs new

Even as we discuss the asset class broadly, it’s good to remember that emerging markets are a collection of very diverse countries at varying stages of economic maturity and political stability. We see two sides of emerging markets: one more defined by innovation and economic stability, and another that continues to be plagued by cyclical swings tied to commodity-related industries and political uncertainty.

The balance of power has shifted to Asian technology and consumer discretionary companies, some of which are now the biggest components of the MSCI EM Index. Mainland-listed Chinese companies, known as A-shares, are being added to the index. And India, now more business-friendly after a series of reforms, has surpassed China as the world’s fastest-growing economy.  

“Some of the risks we see in emerging markets have more to do with country-specific and macro-oriented issues and less to do with certain pockets of the Asia-Pacific and India, where our managers believe there are attractive, long-term opportunities to invest in companies benefiting from technological disruption and secular growth,” says Kent Chan, a Capital Group investment director and emerging markets specialist.

It’s also important to remember that this recent selloff comes after a long period of impressive gains, and it appears profit-taking is among the factors contributing to weaker sentiment.

The EM-dollar relationship

A stronger dollar is making conditions difficult in emerging markets and has contributed to some capital flight. Historically, long periods of dollar strength have been a headwind for emerging markets, especially in cases where countries have relied on dollar-denominated debt for financing needs.

After weakening against several foreign currencies last year, the dollar’s rebound has been driven by the relative strength of the U.S. economy compared with Europe, expected U.S. rate hikes, stronger-than-expected earnings from U.S. corporations and increased uncertainty around trade tariffs.

Will emerging markets see any relief? Capital Group currency analyst Jens Søndergaard says further gains for the dollar may be hard to come by.

“For the dollar to rally further you need markets to start pricing even more Fed rate hikes than what’s already priced. That requires the current strong U.S. growth momentum to continue into 2019. It could happen but given the current trade war uncertainties, and signs of slower global growth ahead, I think we are now at peak U.S. growth,” Søndergaard says.

China’s slowdown

China’s economy in the second quarter grew at its slowest pace since 2016. Expect a gradual slowdown over the next six months and into next year, according to Capital Group’s China economist Stephen Green.

“Moves by the Chinese government to curb risks in the country’s financial system, and ongoing global trade tensions, should contribute to the deceleration,” Green says. “Deleveraging remains a priority in Beijing. While authorities are loosening up financing for infrastructure projects and encouraging banks to lend, I don’t think it changes the situation much in the near term. We may not see a stronger policy response in terms of stimulus until next year when more signs of the economic slowdown build up.”

Though it is slowing, China’s economy is still one of the fastest-growing in the world: Its sheer size, growing tech centers and increasing wealth mean there will always be pockets of opportunity for investors.

Portfolio managers in New World Fund® (NWF), and EuroPacific Growth Fund® have been focused on companies involved in internet-connected platforms, financial services, entertainment and travel. These include Hong Kong-listed insurer AIA Group, which has been seeing increased business in China; Alibaba Group, the world’s largest e-commerce business; and Taiwan Semiconductor Manufacturing, a contract-chip manufacturer for Chinese mobile phone companies, which were all top 10 holdings in both funds as of July 31, 2018.^*

They’ve also selectively invested in companies that may benefit from the government’s focus on curbing pollution and creating national champions in the health care sector.

EM fundamentals look attractive

Despite recent volatility, emerging markets could gain support from a combination of factors.

Corporate profitability and debt measures are stronger and improving. Valuations for emerging markets stocks are trading below their 10-year average on a price-to-earnings basis, and the discount has widened recently. At the same time, aggregate profits for companies in the MSCI Emerging Markets Index are estimated to rise by 16% this year and 11% in 2019 on a year-over-year basis, according to estimates by data aggregator FactSet.

Selectivity is key, according to Chan.

“While we follow the macro developments closely, we invest bottom-up in companies that we believe can continue to grow despite geo-political uncertainty, risks of trade barriers and/or economic slowing, he says. “Furthermore, valuations, in some cases, have become even more compelling for companies that we believe have long growth runways as recent volatility is creating more opportunities to invest with our longer-term view.”