Sunday Start, submitted by Jonathan Garner and James Lord of Morgan Stanley
As regular readers know, Morgan Stanley is pretty bearish on global risk assets. This applies to emerging markets (EM) too, where we've been calling for wider credit spreads, weaker EM currencies, particularly in Asia, and lower equity prices. However, not so long ago the narrative guiding investors ran something like this: The Fed was ahead of the curve, EM bond yields looked attractive in a world of negative interest rates and a US-China trade deal seemed within reach. Meanwhile, EM equity earnings were supposed to be enjoying a 2H19 upswing, led by a Chinese economic recovery and easy comps for sectors like autos and IT hardware.
How quickly things change! In the past few weeks, we've seen the Fed deliver a hawkish rate cut and pass up multiple opportunities to turn more dovish, the US state that it would impose tariffs on all remaining imports from China, loan growth and activity for July disappoint, CNY break 7 versus USD, the US label China a currency manipulator, tensions flare up between India and Pakistan, protests intensify in Hong Kong and Argentina's primary elections deliver a surprise – all leading to sharp moves lower in EM risk asset prices. The bulk of the weakness may now be behind us, and the asset class will probably trough before year-end, but we think there’s a bit more to come in the short term. We wouldn’t be surprised to see MSCI EM equities undershoot our June 2020 base case target of 940 (-4%Y), further losses for Asia FX, and EM credit spreads settle around 380-400bp versus 370bp now.
One key problem is that the global economy is deteriorating faster than offsetting policy action, despite the fact that several EM central banks have begun to step up the pace of easing. Activity is particularly weak in the manufacturing and trade-dependent economies of North Asia, which dominate the EM equities index. Although China could partially offset the impact of additional US tariffs due in early September through additional fiscal easing, we’d still expect GDP growth in that scenario to decelerate further, to 6.0%Y in 4Q versus 6.2%Y in 2Q. China's July data for industrial production (+4.8%Y) and retail sales (+7.6%Y) both materially missed consensus estimates this week. With GDP growth in other major index constituents Korea, Taiwan and South Africa also weakening, we now project aggregate earnings growth for EM of just 1%Y for 2019. Consensus estimates, though tumbling in the last few weeks, still project 4%Y. Moreover, our base case envisions a much weaker EPS recovery in 2020 (9%Y) than consensus (14%Y). Valuations at around 11.0x forward P/E on consensus aren’t sufficiently cheap in our view to compensate for continued earnings risk, and we are targeting a multiple of 10.5x.
Naturally, the weakness in global growth is linked to the trade tensions between the US and China, and CNY's role in that dispute has come under closer scrutiny. We expect gradual declines in CNY. This process acts as a disinflationary force elsewhere, putting downside pressure on global risk assets.
EM credit markets face near-term risks too. This year, virtually all EM fixed income inflows have been into foreign currency-denominated product, so positioning is fairly heavy. Meanwhile, most of the overweights are in the high yield sector, which is sensitive to a global growth slowdown. The performance of the median fund, while strong in absolute terms this year, is now lagging the benchmark, meaning investors will want to act cautiously in the face of any increase in uncertainty and volatility. And guess what, Argentina just injected a significant amount of uncertainty. Investors are likely to take some chips off the table and protect their gains.
What would make us more constructive, and where are pockets of value? For the overall asset class, the passage of time and lower valuations are needed. Policy action (including from the Fed) and natural cyclical forces should eventually help activity to recover. EM risk assets tend to overshoot and undershoot fair value, with particularly large downside moves in the May-to-October time frame; last week's outflow of US$6 billion from EM-dedicated equity funds was the largest since August 2015. Within EM equities, we continue to prefer Brazil and India to Korea, Taiwan and China/HK. We think Brazil can outperform Asia ex-Japan in FX and Russia and Qatar can outperform in EM credit.