Emerging Markets Outpace Developed Markets in the Final Quarter of 2018

by Manraj Sekhon, Chetan Sehgal of Franklin Templeton Investments, 1/15/19

Numerous uncertainties weighed on investor sentiment in 2018 and led to a down year for emerging markets overall, although the fourth quarter saw some outperformance versus developed markets. Manraj Sekhon, CIO of Franklin Templeton Emerging Markets Equity, and Chetan Sehgal, senior managing director and director of portfolio management, present the team’s overview of the emerging-markets universe in the fourth quarter of 2018, along with their current outlook.

Three Things We’re Thinking about Today

    1. The US Federal Reserve (Fed) raised its key interest rate by 25 basis points in December, its fourth increase in 2018, and in line with market expectations. While the Fed lowered its US gross domestic product (GDP) growth and inflation forecasts slightly, it continued to see relatively strong growth in the US economy. US interest-rate hike projections for 2019 and the longer run were also lowered, with two interest-rate hikes expected in 2019, instead of three. While rising rates—by design—apply pressure to growth and inflation expectations, this is not solely restricted to emerging markets (EMs), and most debt ratios are considerably higher in the developed world. EMs in aggregate have shifted to current account surpluses, floating exchange rates and a reduced reliance on US-dollar debt funding. However, those emerging economies (and companies) pursuing less prudent policies have been punished heavily by financial markets. Investors appear to be increasingly discerning between winners and losers, which presents opportunities for active management.
    2. US dollar strength has focused attention on weaker commodity prices and dented investor enthusiasm for emerging markets in recent months—stoking fears that the current climate could lead to a repeat of the 1997-1998 Asian Financial Crisis (AFC). However, we believe these concerns are largely overdone as the last two decades of mass financial reforms have transformed emerging Asia’s financial markets. Twenty years on from the AFC, we regard the economic landscape in many EMs as fundamentally stronger than it was back then. Our experience suggests investors should focus less on what’s going on in the United States, and more on the developments on the ground in the countries themselves. In many cases, EMs have drawn lessons from past crises to strengthen policies and governance. In addition, many EM economies are less commodity-driven then they were decades ago. Therefore, the whims of commodity prices have less influence. Changes in US policy could, of course, still cause pain in EM countries with high external debt. But we have noticed a general shift. Asian monetary policy is no longer as highly correlated with US interest rates and is more dependent on local growth and inflation conditions.
    3. The recent decline in oil prices has helped ease pressure on the Indian rupee, current account deficit and inflation. The Indian economy also continues to perform well; government capital expenditure (capex) through infrastructure spending has progressed well, corporate capex involving capacity expansion is gradually unfolding, and we believe that household capex is also improving. Consumption remains robust as well. India went through a challenging environment recently where shadow banks, typically referred to as non-banking financial companies (NBFCs) in India, suffered liquidity issues, raising concerns of systemic risk and liquidity across the entire financial system. Liquidity has since been normalizing and credit flows returning. While upcoming elections could impact sentiment in the interim, we do not foresee a significant impact on the domestic economy. As such, our assessment of the macro picture and corporate fundamentals (with continued economic recovery and corporate earnings growth acceleration) supports our favorable long-term conviction for India’s market.