Trade War Concerns Rattle Emerging Markets in May

Trade tensions caused investors to back away from emerging markets in May, but there are many reasons to be optimistic about the asset class and the earnings outlook ahead, according to Franklin Templeton’s Emerging Markets Equity team. The team outlines recent news and events influencing the market and where pockets of potential opportunity might be found.

Three Things We’re Thinking About Today

  1. Market sentiment turned negative in May, when concerns emerged of an escalation in the US-China trade war following US President Donald Trump’s decision to impose a 25% tariff on US$200 billion in Chinese imports, followed by China’s announcement that it will impose new tariffs on US$60 billion of American goods in response. The decision to include Huawei in the US Entity List only further acerbated the situation. Undoubtedly, the increase in tariffs will impact many Chinese producers, with some companies already shifting manufacturing to other countries. However, China is turning less dependent on trade—at present about a third of its gross domestic product (GDP) comes from foreign trade compared to almost 65% more than a decade ago.1 Instead, the key underlying drivers of China’s growth have been shifting toward innovation, technology and consumption. If China’s rebalancing efforts result in an economy that is more sustainable, in our view, it would almost certainly continue to be a structural growth driver for emerging markets (EMs) in the decades to come.
  1. MSCI’s semi-annual rebalancing, which was accompanied by the inclusion of Saudi Arabia in the MSCI Emerging Markets Index2 and the reclassification of Argentina from frontier market (FM) to EM status, took place on May 28. MSCI also increased the inclusion factor of China A shares to 10% from 5%, doubling its index weighting to just under 2%. A change in methodology also led Thailand’s weighting in the MSCI Emerging Markets Index to increase to about 3%. MSCI’s decision to upgrade Saudi Arabia to EM status puts it firmly on the radar of international investors, and in our view, is a positive step for the Middle East region’s transition into mainstream EM investment. Following its addition to the FTSE Emerging Markets Index last year, Kuwait is on MSCI’s watchlist, with an announcement for upgrade expected shortly. The rebalancing likely led to portfolio inflows into these markets from passive investment strategies, while markets which saw their weightings trimmed, such as South Korea and Taiwan, saw outflows. Active portfolio managers, however, have more flexibility and can focus on company fundamentals as opposed to being restricted by market index weightings.
  2. Russia remains one of the most undervalued markets globally, in our view, despite a very strong performance over the past three years. Many international investors have avoided this market because of economic sanctions against the country. However, we believe Russia’s fairly self-sustained economy has limited the impact of sanctions. While the economy has proven to be resilient, we have seen many companies take steps to adapt and flourish in the current environment. In some cases, restricted access to Western technology has spurred Russian companies to invest in building their own ecosystems, which contributes to more sustainable growth. Moreover, corporate governance in many Russian companies has improved significantly. For example, many companies have increased dividend payouts and undertaken share buybacks to improve shareholder value. Overall, we believe Russia continues to offer interesting opportunities for investors and exposure to select well-established companies across the information technology, financials, energy, materials and consumer-related sectors could serve well for diversified EM mandates.