We expect emerging market equities to outperform developed market equities in 2019. There are three key reasons why we feel this will happen.
First, the gap between GDP growth in emerging and developed countries is likely to widen next year. It will be the first time that has occurred since 2016. In the latest IMF growth forecasts, shown above, growth in emerging countries is expected to accelerate somewhat while growth in developed markets will ease over the next few years. By 2020, this gap is expected to widen by almost a whole percentage point. Historically, the gap between growth rates in emerging and developed markets is one of the strongest drivers of the emerging market equities relative to their developed market counterparts.
Second, while we expect the Federal Reserve to keep hiking rates, we also believe it will do so very gradually. In addition, investors could start to anticipate an end to the tightening cycle later next year. Assuming some normalization of monetary policy outside of the US, we expect the US dollar to weaken. A stronger US dollar often means tighter financial conditions. For example, a significant portion of emerging sovereign and company debt is denominated in dollars. Therefore, a weaker dollar implies looser financial conditions for emerging countries.
Third, emerging markets are cheap. The prolonged underperformance of emerging market equities has made valuations more attractive compared to other regions, especially the US. The trailing P/E ratio of the MSCI Emerging Markets Index has fallen from 16 earlier this year to its current level of 12. This is cheap in both absolute and relative terms. While valuation is seldom a trigger for a change in market leadership, we think it could be an important catalyst for emerging market relevance when the relative outlook starts to improve.
Obviously, what appears to be a bright future for emerging markets also comes with a number of significant risks. Some emerging economies like Argentina and Turkey look weak at best. These economies are particularly vulnerable to any adverse shock to global economic conditions or investor sentiment. At the same time, most of these economies are relatively small and unlikely to cause a widespread crisis across emerging markets.
If the US economy overheats, that would be bad news, as well. In that scenario, the Fed would tighten monetary policy more aggressively, causing liquidity to fall and the US dollar to rise. Finally, emerging markets remain relatively vulnerable to any escalation in the trade war between China and the US. While equity prices now reflect a long-term trade dispute with some resulting loss of economic momentum, bigger tensions could hurt emerging markets going forward.
In addition to emerging market equities, we also think there will be opportunities in Chinese A-shares. A key driver for this is that index providers are increasing the weight of Chinese A-shares. As a result, foreign investors will likely increase their exposures to A-shares. After this year’s sell-off, fundamentals, especially valuations, look increasingly attractive, especially as we expect fundamentals to improve throughout the year.
The announcement by FTSE to add A-shares to the FTSE Global Equity Index Series with a 25% inclusion factor and MSCI’s proposal to increase the inclusion factor from 5% to 20%, reflect China’s ongoing progress on capital market reforms. After the 25% inclusion, A-shares will account for 5.6% of the FTSE Emerging Index. In MSCI’s case, the pro forma index weight of China A-shares in the MSCI EM Index would be 2.8% in August 2019. The addition of China A mid-cap securities with an inclusion factor of 20% in May 2020 would increase the pro forma weight further to 3.4%. At full inclusion, A-shares would take up nearly 15% of the emerging market index and all China stocks would account for over 40% of EM.
The China A-share market has already witnessed robust inflows this year. As a result, foreign ownership of China onshore equities had risen to 3.2% by Q2 of 2018. This is, however, still low compared to other major markets: Taiwan (26%), Korea (34%) and Japan (30%). Assuming full inclusion of A-shares in the MSCI and FTSE by 2025, this could generate an estimated USD 70 bln to USD 100 bln in annual inflows into the A-share market and bring the foreign ownership up to 8%.
With China seeing more participation from foreign investors and a rising awareness of ESG, the corporate governance will gradually improve for Chinese companies. The focus of investors will also gradually shift towards more long-term fundamental drivers even though it could take time given the large proportion of retail investor participation. Despite the expected increase in foreign investment, the valuation of the A-share market is now at a level that is close to the historical minimum, with the P/E ratio trading at 9.8, compared to its historical average of 15.1. The price-to-book ratio has fallen to 1.5, below the historical average of 2.7. Valuation levels have become significantly more attractive this year.
As mentioned, China’s economy will face some challenges from the prolonged trade friction between China and the US and its already elevated debt levels, leaving it little room to stimulate the economy with credit growth. This is part of the reason why sentiment surrounding A-shares remains low, even though at the macro level, China is now shifting towards a looser monetary policy and more expansionary fiscal policy. We believe, however, that sentiment has become a bit too bearish and that fundamentals, such as profitability, will slowly improve, helped by the positive policies and reform measures introduced by the government.
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