By Chanchal Samadder, Head of Equity ETFs, and Philippe Baché, Fixed Income ETF Engineering & Product Development at Lyxor Asset Management.

Emerging markets outlook 2019

After a largely lacklustre 2018, sentiment on emerging markets has improved since the beginning of the year. Capital flows have recovered as a result. So what’s next?

Easing trade tensions, orchestrated central bank retreat from policy tightening, and dollar weakness have been the key drivers of performance and flows so far. And, for now at least, we don’t see that changing.

Conditions look fair for equities then, but some areas are likely to provide greater opportunity than others, so some selectivity wouldn’t go amiss. We expect returns to differ and diverge between countries and regions as individual idiosyncracies come to the fore.

When it comes to bonds, we expect more policy support from most EM central banks. As long as US rate expectations remain subdued, easier external funding conditions should give those countries with real currency sensitivity or heavy external debt burdens more breathing room. Lesser inflation pressures also offer ample scope for rate cuts. Local and hard currency bonds should benefit for a while yet.

Don’t, however, wait too long before stepping in. Trade will remain a talking point and this round of the Great Game between the US and China is far from played out. Tighter liquidity conditions will weigh on returns in the longer term.

Our equity outlook for the key countries and regions:

Positive on EM Asia

EM Asia is our favourite equity region because of Fed dovishness, the trade war ceasefire and a softer stance on deleveraging in China. A longer US cycle – one that endures beyond H1 2020 – would also be supportive. Earnings growth and valuations appeal.

China: Escalating trade tensions, a weaker yuan, and deleveraging all weighed heavily on stocks last year. Growth is slowing. Seen differently though, growth is still twice as fast as the US and three times faster than the rest of the developed world. China is also one of the few large economies with the ability to relax fiscal policy further as recent announcements have proved. Upside potential is huge over the long term provided the model keeps shifting toward sustainable growth. Valuations also seem reasonable.

India: India is another country with a lot to offer. Parliamentary elections in May and tensions over Kashmir could be short-term stumbling blocks, but the structural story is intact. Corporate earnings are improving, and we expect to see further profit normalization for financials. The next five years should be about growth and corporate re-leveraging – a combination well capable of improving share price performance. Domestic inflows have also been a source of real support. They have helped reduce volatility, lessen sensitivity with other emerging markets and dampen drawdowns. There’s little doubt in our mind that Indian equities should be a core holding in EM portfolios.

Indonesia: We remain positive with earnings growth still strong and forthcoming elections likely to pass without too much alarm. Limited oil and yuan sensitivity offers growth at an affordable price. Currency stability should support foreign capital flows into equities and bonds.

Malaysia: Macro indicators are stabilizing. The country is also benefiting from a recovery in raw material prices, which has been reflected in export growth. However, valuations remain near-average despite having underperformed other Asian peers quite significantly over the past 12 months – a factor which could gate any gains.

Korea: Their recent rebound notwithstanding, Korea equities are likely to continue to underperform Asian peers with more earnings downgrades ahead for the tech sector.

Taiwan: The outlook is also bleak for Taiwan equities. Valuations remain marginally above average and a case for re-rating can only be made should there be signs of improvement in the tech sector – something which is unlikely for now.

A neutral stance on Latin America…

Political and policy uncertainty will be key themes and are likely to hinder returns, particularly in post-electoral Brazil and Mexico. Both countries are very sensitive to moves in US interest rates and the dollar, leaving them vulnerable to bouts of volatility.

Brazil: A reality check is likely with the strong recovery of H2 2018 running out of steam and investors in need of much greater clarity on the reform process. The positive long-term support from the more market-friendly programme is now well priced-in. With GDP growth sluggish, we see limited corporate growth ahead.

Mexico: Prospects are unclear under a new, staunchly leftist leader. A deteriorating trade outlook and tighter financial conditions are likely to weigh on demand, but stronger government investment could drive growth in some sectors. Low valuations could make the market attractive on a tactical basis.

…and EMEA

Russia: Worsening tensions with the US will keep volatility high. The positive way oil prices have responded to the OPEC+ agreement on production cuts should provide some support but the possibility of heavier US sanctions weighs on the long-term view.  Caution is advised despite cheap valuations.

Poland: Domestic demand, consumption and investment growth should remain solid, but corporate profits have been declining on the back of rising competition and cost pressures. Pre-election fiscal stimulus plans may provide some relief, but the anticipation of those elections in 2020 may bring more volatility.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)