Chief Investment Strategist
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We see opportunity building in beaten down emerging markets despite heightened US policy risks
Worsening trade disputes, tightening US monetary policy and idiosyncratic political risks around the world roiled many markets over the summer months. These risks were increasingly discounted in non-US equity and credit markets - particularly emerging markets - during the period.
After reducing our allocation to non-US equities in both EM and DM markets in July, the Citi Private Bank Global Investment Committee (GIC) reiterated its asset allocation today with Global Equities at +1.5% and Global Fixed Income at -1.5%. While holding at the current weightings for the time being, we see opportunity building in beaten down emerging markets, despite heightened US policy risks. We suggest investors rebalance to avoid positions overly concentrated in US assets.
Despite some positive trade announcements from US, European and Mexican officials in July and August, uncertainty over US tariffs remains significant. The largest dispute between the US and China has clearly worsened, with new tariffs soon to be collected on $385 billion in goods traded between the two sides. During the same timeframe, Argentina and Turkey spiraled into a confidence crisis, sparking a fairly severe round of risk aversion in most EM currencies and asset markets.
This is despite the two countries being outliers, with unusually large borrowing requirements compared to other EMs (including countries which are net lenders). Brazil also faces near-term Presidential election uncertainty which is impacting a large EM index component. The combination of these issues, along with US dollar liquidity pressures, set in motion a correction in many international asset prices, including those with favorable valuations.
In the past two months emerging markets total returns were -6.5% in US dollar terms while hard currency EM bonds dropped 1.5%. Overall non-US equities fell 3.7% in USD terms. Unlike periods as recent as 2016, the declines occurred while global growth indicators showed only marginal slowing. Earnings per share for world emerging markets are on track to rise 15% this year.
The drop in EM shares relative to fundamentals appears to be the largest “disconnect” since 1994, when EMs were shocked by unexpected tightening from the US Federal Reserve. US trade risks appear to be the largest driver of this performance, which has also impacted non-US Developed Markets in Europe and Asia.
In contrast, US equity and credit markets have been unusually stable through the period. This is despite potential negative tariff impacts on many US firms highlighted by the firms themselves. While we remain confident in the US growth and earnings outlook, a very large rise in US share repurchases during the first half of the year seems to have unusually insulated US markets.
The sharp increase in US share buybacks appears to stem from the corporate tax cut enacted at the start of the year, and is discrete in nature. With US equity and high yield markets sharply outperforming international equities and emerging markets debt, and with trade risks now heavily anticipated in many non-US valuations, we would urge investors who have become too concentrated in US markets to rebalance as appropriate.
While we have not downgraded our concerns over the impact of future trade disputes, valuations and fundamentals now suggest a worsening outlook is priced into many non-US markets. As key political elections pass in coming months, and markets enter a seasonally strong period, this could result in a very widespread rebound in many markets, including those with poor fundamentals.
In consideration of the full 12-18 month tactical return window we target, the impact of US monetary policy tightening should be considered if the global recovery remains intact, as we expect. While we will consider making upward adjustments to our risk allocations if policy uncertainties ease, we see the usual divergence in various ‘opportunistic’ portfolio allocations.