Emerging markets: The drivers creating conditions for stronger returns

Demand looks strong in key EMs and our Pendal Global Emerging Markets Opportunities investment team believes US dollar softness – when it comes – will create conditions for strong returns

EMERGING equity markets are driven by two broad global drivers:

• Global end demand and trade
• US dollar interest rates and liquidity

Individual markets have their own business and credit cycles – as well as political environments – but these are always interacting with the main global drivers.

Right now, one of the challenges for emerging markets investors is interpreting differing signals from these drivers.

Global demand

Indicators of global demand look supportive for emerging markets.

In June, manufacturing data (measured by Purchasing Managers Index surveys) continued to look strong in many emerging countries, while Asian exporters Korea, Taiwan and Vietnam saw strength in new export orders.

June manufacturing PMIs were 52 in Korea, 53.2 in Taiwan and 51.1 in Mexico, with exports growing in all three countries.

A PMI above 50 suggests expansion, below 50 indicates contraction, and 50 means no change.

Recent PMIs also indicate growth in domestically driven emerging economies such as India (57.5 for May), Brazil (52.5 for June) and Indonesia (50.7 for April).

Consumer confidence also looks robust in these three markets.

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China has two PMI data series with some conflicting messages, but both measures show weaker export and domestic orders.

In the Gulf PMIs look very strong. UAE, Saudi Arabia and Qatar were all above 54 for June.

US dollar

So far so good. But the other half of the story is the US dollar’s continuing strength and caution about the future direction of US monetary policy.

Against the US Dollar Index (DXY) basket of developed market currencies, the USD has strengthened by 3.5% year to date. Medium-and-longer-dated US government bonds have seen yields rise by about 0.4% over the same period.

No other major emerging market central bank has yet felt the need to follow Bank Indonesia’s surprise 0.25% policy interest rate hike in June.

But, following the US, yield curves across EM remain higher year-to-date, and the expected timing of policy interest rate cuts in markets like Brazil and Mexico keeps getting pushed out.

Meanwhile the stronger US dollar has seen corresponding weakness in emerging market currencies such as the Brazilian Real (-11.6% against the US dollar in the second quarter), Mexican Peso (-10.6%) and Indonesian Rupiah (-3.3%).

This reduces returns to international investors.

Although Mexico saw a surprisingly strong election win for the left-wing Morena party in the quarter, the Mexican Peso weakened alongside other similar emerging market currencies.

The strong US economy is good for emerging market exports (and remittances) but less good for US dollar liquidity.

In this environment we continue to find opportunity in some emerging markets where growth (particularly, corporate earnings growth) remains attractive, even if the current US liquidity environment is a headwind.

These particularly include Mexico, Brazil and Indonesia. Each has seen strong upward revisions to corporate earnings expectations this year.

Local currency weakness has been a drag on returns in each of these countries, but we remain confident US dollar softness, when it comes, will create the conditions for strong returns from these markets.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

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