An investor walks besides a screen showing stocks trading at the upper limit at a securities trading firm in Shanghai, China. (Photographer: Kevin Lee/Bloomberg News)

Bull Case for Emerging Markets Has One Big Caveat

(Bloomberg Opinion) -- After a bruising 2018, emerging markets will probably be the place to make quick money next year. 

It’s not even December, but major Wall Street investment banks have already issued their outlooks for 2019, and the mood is hopeful. Morgan Stanley went outright bullish, double-upgrading the asset class to overweight from underweight. Goldman Sachs Group Inc., meanwhile, said “there will likely be a good number of tradable rallies” even if 2019 turns out to be another painful year.

Underpinning their calls is a sharp expected slowdown in U.S. earnings. Morgan Stanley strategist Jonathan Garner estimates growth will slump to 4 percent from 23 percent this year. While earnings increases in emerging markets will accelerate only modestly, to 7 percent from 3 percent, there’s no longer a glaring differential.

Emerging markets have suffered this year in part because the U.S. has been growing at the speed of a developing nation, without the associated currency or governance risks. As the impact of President Donald Trump’s corporate tax cut fades, money may leave in search of higher returns. The prospect of a potential pullback in interest rate hikes, signaled by Federal Reserve Chairman Jerome Powell in the U.S. on Wednesday, will be supportive for emerging markets.

Mean reversion, or what goes down must come up, is also a factor, as I noted yesterday. Volatile in nature, emerging markets can be a haven for day traders even when they end the year in the red. A good example is 2014, when the MSCI Emerging Markets Index recorded eight months of gains before closing the year with an annual loss of less than 5 percent.

Bull Case for Emerging Markets Has One Big Caveat

There’s a caveat to the bull case, though: China.

The prospects are less clear for the elephant in the emerging markets room. To some extent, this is an issue of timing. Like holiday shopping deals, outlook reports from investment banks arrive earlier every year. That may make strategic sense for them (by mid-December, who wants to read another 100-page report?) but it means analysts are compiling their forecasts when China isn’t even close to showing its hand for the new year.

The Ministry of Finance does its budget calculations at the end of the calendar year. But Beijing doesn’t announce its full-year GDP growth and fiscal deficit targets until weeks after the Lunar New Year, which often falls in February. China’s business elites have been lobbying for Trump-style tax cuts for months; these won’t come about until spring at the earliest.

Morgan Stanley, for one, refrained from upgrading China because it has to “wait for more details on China’s countervailing fiscal policy easing.” The economy slowed for a sixth straight month in November.

I do wonder whether we can turn bullish on emerging markets while taking a wait-and-see attitude on China. 

Aside from the fact that China Inc. constitutes 30 percent of the benchmark MSCI index, emerging market currencies and stocks also tend to be highly correlated with the yuan.

Bull Case for Emerging Markets Has One Big Caveat

Dollar-based global investors are quick to sell whenever the yuan dips. Developing nations, they fear, may interpret yuan weakness as Beijing weaponizing its currency and engage in some competitive devaluation themselves. But we won’t have a good sense of where the yuan is likely to be until we see Beijing’s 2019 budget. 

What’s the takeaway then? There’s money to be made in emerging markets, but only for nimble investors. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

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