We believe emerging markets go right or wrong at the country level. Understanding the diverse emerging markets universe in a top-down way can be a major source of portfolio outperformance. 
When it comes to the global macro-sensitivities of different emerging markets, these can be assessed in different ways. One of the key drivers, though, is a country’s exposure to US interest rates and the strength of the US dollar. This is generally most marked in those countries that run current account deficits, and that relationship played out clearly in 2018, in particular in those countries with the weakest current account balances seeing the steepest falls in currencies and equity markets. With the easing and now apparent reversal of Fed policy, the pattern of relative performances of 2018 has largely been reversed year-to-date in 2019.
India and the UAE: Domestic demand stories
Turning to forward investment opportunities, the emerging market domestic demand space, particularly in current account deficit markets, has generally been a tough space in US dollar terms since the ‘taper tantrum’ in the second quarter of 2013. Recent moves in markets point to this now being the primary area of opportunity, particularly where valuations have been driven down during the 2018 sell-off. We would emphasise the exciting combination of supportive top-down conditions, good quality companies and attractive valuations.
Just to highlight some areas we have become significantly more positive on in recent months, Indian mortgage lenders substantially de-rated in 2018, with regulatory pressure and volatility in the Indian fixed income market causing some high-profile failures. With global liquidity tight, the central bank (the Reserve Bank of India) was unable to cut rates even as consumer price inflation declined to 2 per cent.
Now that the global liquidity outlook has eased, there is the prospect of the Reserve Bank of India continuing to cut rates even as Indian credit growth recovers. India, unusually in emerging markets, has not had a credit cycle in the last ten years, so the current pick-up in credit could be enduring. Alongside that, India has ongoing demand for 5-10 million residential units per year needing financing, and we see selected Indian mortgage lenders as amongst the best opportunities in the emerging markets world.
In addition, property stocks in the United Arab Emirates (UAE), particularly in Dubai, have performed very poorly as the real estate cycle there seeks a bottom. Through its currency peg, the UAE effectively imports US monetary policy, which has coincided with oversupply of development properties to push both real estate prices and related stocks down significantly. Even with a more benign US monetary outlook, the residential property market may take some time to recover. However, property companies exposed to the tourist trade through retail, entertainment and hospitality assets have similarly de-rated, despite tourist arrivals to Dubai rising 5 per cent in 2018. As the Fed’s shifting stance improves financial conditions in Dubai, we expect the highly attractive valuations in Dubai property stocks to lead to strong performance.
Mexico, sí. Brazil, não
Other opportunities will present themselves. Brazilian equities look very expensive against their history despite growth remaining anaemic, implying some very positive market expectations for Brazilian politics and social security reform, while Mexican equities look markedly cheap relative to history, despite growth being fairly strong, implying some extremely negative market expectations for the political environment there. Given that we do not expect revolutionary change in politics in either country, we substantially prefer Mexico to Brazil, again with a focus on domestic demand.
China is a slightly separate story, China has also seen significantly tight monetary policy in the last 18 months. That is not directly the consequence of US rate hikes, but the strength of the US dollar does put pressure on the Chinese renminbi and has been a constraint on the People’s Bank of China’s ability to act. Activity indicators remain very soft in China, and we think that more stimulus through faster credit creation remains key to a recovery in China. It may be that we are now at that point, certainly the January all-system financing number was very large, both against history and against expectations. So, China may be an investment opportunity later in 2019, but it isn’t a direct beneficiary of the Fed’s new-found caution. It is important to note that all-system financing tends to see some large prints around the Lunar New Year festival, and the February print will be key, with the potential to either confirm or dash hopes that the credit stimulus is underway. It is also important to note that, given the size of the Chinese financial system, a high level of monthly stimulus must be maintained for some time to turn the economy round.
Our optimism on emerging markets
In summary, after five tough years, we think the combination of a more benign US monetary outlook and some extremely compelling valuations makes for powerful opportunities in the emerging market domestic demand space. Our process remains structured to first seek opportunities at the country level, and then seek those stocks that offer optimal economic exposure within that country. We find the current investing environment to be target-rich. Many clients we speak to are conceptually positive on the emerging market equity space, but have been put off from increasing allocations by, first, weak markets in 2018, and then by strong markets in 2019 year-to-date. We think that this approach carries the risk of missing out on the potential gains that are now available in emerging markets.
James Syme is manager of the JOHCM Global Emerging Markets Opportunities fund. All views are his own and should not be taken as investment advice.