Sao Paulo: If Jason Daw is right, some of the world’s biggest investors are setting themselves up for a major disappointment. The Singapore-based strategist at Societe Generale, one of the few to anticipate the slump in emerging markets beginning in January, sees no imminent turnaround for the asset class. He said the modest rally in currencies since September, led by Turkey’s lira, Brazil’s real and South Africa’s rand, is temporary and that slower global growth and additional tightening by the Federal Reserve will continue to weaken developing-nation currencies.
“It will be a multi-year process for investment behavior to adapt to less generous dollar liquidity conditions after a decade of easy money," he said. “The hurdle for capital to flow back into emerging markets is high and a significant macro catalyst is required to turn the narrative around."
Daw is among a cadre of contrarians including Man GLG money manager Lisa Chua, Bank of America strategist David Woo and Harvard economist Carmen Reinhart warning of additional risks for emerging markets, even after eight consecutive weeks of inflows into the asset class. They point to a gloomier growth outlook amid an escalating trade war, the prospect of further dollar strength as well as pockets of fragility in China, Brazil and India.
That would compound the pain from an already tumultuous 2018 in which emerging-market equities slid into a bear market and every major currency in the developing world declined against the dollar.
Some combination of Chinese stimulus, an end to the U.S.-China trade war, a pause in Fed tightening due to inflation and higher oil prices could help spur a rebound within the asset class, according to Daw.
While bears are in agreement that emerging markets will remain under pressure in 2019, they’re split on what will be the primary source of pain.
Waiting Out The Fed
Daw said the time to dive in to emerging-market assets would be when the Fed starts to cut rates, and that could be 18 months away.
“I get the feeling consensus is on the more optimistic side," he said. “We have believed that EM FX could weaken since the end of last year."
He sees some value in Argentina, which led emerging-market currency declines this year. The South American country is also looking more attractive to Chua.
The Societe Generale strategist also recommends shorting the Brazilian real against Mexico’s peso as the initial market euphoria following Jair Bolsonaro’s election wanes.
Woo’s biggest concern is that Xi Jinping’s government has no incentive to make concessions on trade, especially with Donald Trump hobbled by congressional gridlock. Domestically, Chinese authorities must juggle the need for stimulus with the desire to rein in runaway home prices. Woo recommends shorting the Indian rupee and Mexican peso as the slowdown in China weighs on assets across the developing world.
“You want to buy EM?" he said. “I wouldn’t touch EM with a 10-foot pole until there’s a resolution between the U.S. and China."
Another China bear, John-Paul Smith, founder of Ecstrat Ltd. in London, said he’s steadfast in warning that a slowdown will hurt emerging-market equities. He recommends being underweight or zero-weight Chinese shares, Russian stocks and South Korea’s won, given their sensitivity to trade and commodities.
“I expect all three to have significant downside in dollar terms between now and the end of 2019," Smith said.
It’s best to remain underweight emerging-market bonds as spreads potentially widen to 450 basis points over U.S. Treasuries, according to Kathy Jones, chief fixed-income strategist at Charles Schwab & Co. in New York. She expects the U.S. dollar to remain firm near term, while additional Fed tightening, slowing Chinese growth and lower commodity prices also prevent a big rally.
“There is a case for a rebound in EM sometime in 2019 once the peak in tightening financial conditions has been reached," Jones said. “We just aren’t seeing it in the near term."