Overview of EM asset calls

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EM-DM growth differentials will likely slip further. No strong case for a big re-rating in equities, but things may improve from Q2 '19 when earnings downgrades should end. Target: 7-8% returns.

Prefer Value style today amidst further adjustment in EM Growth stocks. Strong preference for Growth over the medium and long term.

China makes choices between external stability and growth for the first time in 25 years. This impacts the size and nature of its stimulus.

A better year for EM currencies at an aggregate level, but pressure shifts from high yielders to growth sensitive Asia. 1-2% losses in spot allow for small positive total returns.

We enter 2019 with a preference for hard-currency debt over local-currency debt. Local debt should do better in 2H19, and through the full year. We look for 4% and 6% in hard- & local-currency debt in 2019.

EM growth challenges return

Emerging markets will continue to face uncertain times into 2019 as most of the developed world moves into late cycle, and China takes another step lower during its structural slowdown (Figure 13). However, the nature of EM’s challenges will not remain the same. While 2018 has really been about dealing with a serious repricing in US yields, 2019 will see more investor concerns about EM growth, which will be negatively affected by tightening financial conditions. This is set to shift the pressure from high-yielding, current-account-deficit markets to low-yielding, growth-sensitive Asia.

EM’s challenges will continue in 2019, but will be of a different nature

In 2018, the gap between EM and DM growth shrank: while EM growth decelerated, DM growth accelerated. This happened in the context of improving global growth, however. In 2019, we expect both EM and DM growth to fall. We forecast global growth to fall 30bp to its long-term average of around 3.6%, while EM growth is likely to slip a little more than DM growth, leading to further compression in growth spread between the two regions (Figure 14). In 2020, growth should recover both in absolute and in relative terms. But, broadly, over the next two years EM’s growth premium to DM is likely to remain in the bottom quartile of its 20-year distribution.

EM’s growth premium over DM comes lower in 2019, this time in the context of slightly weaker global growth

Figure 15: Capital flows into EM and EM-DM growth differential

Source: Haver, UBS

Figure 16: Per capita real GDP growth (%y/y, average, PPP GDP-weighted)

This matters because EM assets are driven primarily by growth. Even for local bonds, which are notionally driven by inflation and carry, 60–70% of the performance variability is explained by FX, a growth-driven variable. It is not surprising that the spread between EM and DM growth is the most crucial factor in determining overall capital flows (Figure 15) and driving EM’s relative performance.

Recent work by the IMF1 suggests that the convergence in EM per capita incomes to those in DMs is likely to evolve at a slower speed than it has in the past 10 years (Figure 16). This should not be surprising considering the growth profile of China and the commodity-producing countries. What will also matter for assets is the quality of growth, valuations and the international context.

The gap between EM and DM growth is an important driver of relative asset performance and of capital flows

Late cycle is not kind to EM, but no blow-ups this time

In the coming year DM growth will be less ‘hot’ than it was in 2018. It is nonetheless significant that output gaps have closed. We have tried to measure the stage of cycle in US and Europe based on signals from different markets (See Box 1).

Historically, EM assets have not performed very well when the US output gap has been closed, and growth nonetheless remains above trend (Figure 17).

Despite deepening growth challenges and cost of equity pressure from output gaps closing in advanced economies, it is worth bearing in mind that a narrow minority of EM countries that have serious balance sheet problems have already seen a significant adjustment of their risk premia this year (Figure 18). Lower growth will still put pressure on returns, but we do not see the source of volatility significant enough to become contagious across the asset class. We have historically delineated EM’s reasonable balance sheets from its weak income statements, and this characterisation remains valid.

Are current valuations already pricing the new growth, inflation and credit profiles and the additional trade risks? The answer depends on the asset class.

Equities: Cheapening as expected, amid tighter liquidity

EM valuations relative to the MSCI World (DM) are now at the 35th percentile of their 15-year distribution (Figure 23). However, EM’s valuations have de-rated exactly in line with what would have been expected in the context of the rise in local currency bond yields and credit spreads (Figure 24). There is little additional risk premium, we believe, priced in on earnings volatility, trade-related or otherwise. Given that we expect stable local currency yields and slightly wider credit spreads next year, we think the case for a major re-rating in EM equities is weak.

EM assets are typically under pressure in late cycle, as already seen this year

Weak income statements but reasonable balance sheets

Having de-rated in line with rising bond yields and spreads, EM unlikely to see a big re-rating