Of Currencies, Trade and Other Clouds

Emerging markets have struggled in the first half of this year amid a storm of uncertainties. Franklin Templeton Emerging Markets Equity’s Chetan Sehgal examines issues that have acted as clouds on the asset class—including a stronger US dollar and trade skirmishes—and highlights some positive longer-term fundamentals. He thinks some of the concerns are overblown.

After a strong couple of years, emerging markets overall have struggled in the first half of 2018. Investors have focused on negative factors, particularly rising US interest rates, US dollar strength and trade concerns. However, we think some of these fears are overblown.

We recognize that a backdrop of rising US interest rates and a strengthening US dollar—while reflective of a strong US economy—can impact emerging markets. While a strong US economy is good news for the global economy (including emerging markets), higher interest rates can make it costly for borrowers to service their external debt. So, local currencies can—and have—come into pressure as servicing dollar-denominated debt becomes more difficult. Capital flows have reversed out of what’s perceived to be “riskier” markets. We have seen a flight of capital out of emerging-market equities this year, and some currencies have weakened to the point where they appear to be quite undervalued right now relative to the US dollar. We don’t think markets are reflecting the positive fundamentals we see.

Certain countries with strained finances continue to attract the bulk of headlines, but it is worth noting their relatively small size in the context of the broader emerging-market asset class, as well as the extent to which their fundamentals are weaker. For example, Turkey represents only 2% of MSCI Emerging Markets Index, Pakistan 0.5%, and Argentina is not even in the index yet.1