The dominant emerging markets story currently is the trade war, or developing trade war, between China and the US.
Let’s be clear, higher tariffs and more trade barriers are negative for economies, for trade, for inflation, for investment, for employment and for capital markets.
The question is to what degree does this situation worsen from here? We would say, given the history of US President Donald Trump in his relatively short leadership period, we would be hopeful that the worst case will not occur here.
Why do we say that? Well, firstly, if we look at recent history, the US administration imposed stringent tariffs on ZTE, the Chinese telecom equipment supplier, which would have effectively put a business employing 80,000 people out of business.
President Xi said this was clearly not part of good relationships, look at how China have helped you with North Korea, and so on – and what we have seen is the US administration back away from that.
We saw the US administration also impose tariffs on Russian aluminium makers, Rusal and En+.
This caused aluminium prices to spike 30 per cent and again we have seen the US administration now decide it would like to negotiate a compromise solution to the issues there.
On Iran, the decision was taken to sanction the country very aggressively and, in particular, to prevent its sale of oil products.
Again, the outcome of this policy is significant strength in the oil price, which is negative for global growth. The US administration is now asking the Saudis if they could pump more oil in exchange and again we might see some more moderation of this stance.
Lastly, of course, North Korea, where American policy towards North Korea was incredibly aggressive three months ago, and now they seem the best of friends.
So, if you like, what we have seen is a situation where the American president and the American administration start off incredibly aggressively in any negotiation and then tend to back-track or moderate their stance later on.
So again, this is a negative environment for the market, but we think worst case scenarios are probably not central to what we expect at this point.
Rather, we believe it is about having a resilient portfolio and defensive portfolio in this environment and we think performance has helped us to mitigate some of those effects.
Chinese growth – walking the Goldilocks tightrope
The market is broadly concerned about Chinese growth. It always is one way or another and I think the market would like to see a Goldilocks scenario in China, so not too hot with growing leverage and growing debt because of the risk that brings, but not too cold with major deleveraging because of the impact that might have on growth.
This leads to the Chinese government effectively walking this tightrope which the market gets concerned about.
On the negative side, the market looks at growing bond defaults and says that this is a sign of greater financial distress in China – not true.
What this is a sign of is greater financial discipline in China and that these poor companies with weak balance sheets can no longer roll the bad debts. The bad debts are always there but now they can’t refinance them.
What is very good to see in China is an attempt to tackle the moral hazard in the financial markets. At the moment, many Chinese investors buy high interest, high risk products.
They are not concerned about the risk. They are not concerned about the high interest. They are seeing those products as guaranteed by the government.
Now, if you want to buy one of these high-risk products, you are sat down by the bank, you are videoed, you are told that these products are risky, you may lose money on them, they are not guaranteed, and you are videoed responding yes to those questions to make sure you understand that. This is a clear attempt to prevent mis-selling in their financial market and break that cycle of moral hazard.
I think also on the positive side what we are seeing is the government periodically injecting liquidity, so the authorities are alive to the risk. In particular, just last month we saw reserve requirements eased for the banking sector there.
So, we think the Chinese government understands the policy choices and at the moment is navigating its way through that very strongly.
The MSCI recently announced two major changes to the indices within the next year – putting both Saudi Arabia and parts of the Argentine market into their EM index.
Saudi Arabia – a significant and uncorrelated market
Saudi Arabia is interesting. It would be about 2.5 per cent of the MSCI EM index.
With Aramco, assuming it is listed, that might be 4–5 per cent, so quite a significant market, also an uncorrelated market. Foreigners only own 2 per cent of this market.
I think one of the things to look at there would be the very recent announcement that women will be allowed to drive.
At first sight, this seems like just a very positive social policy, but actually you can look at it as a far more significant economic policy move.
If we look at female participation in the Saudi workforce, it’s 20 per cent. Partly that is because of their culture and partly that is because it is very difficult for Saudi women to commute.
Clearly, if they are allowed to drive, that creates a lot more opportunities for them to work, to spend, to consume and it is clearly very positive for economic growth.
There are actually a lot of potential jobs open in Saudi Arabia now, given that a million expats have left Saudi Arabia in the past two years. Allowing women to drive is not just a positive social policy – it’s a very positive economic policy for the Saudi economy.
We think the whole process of reform in Saudi Arabia makes it an interesting market to look at.
Argentina – a chequered history but with some very good companies
The intention to allow some Argentine companies into the index is also interesting. Clearly, back in history, Argentina was an emerging market. It then got downgraded with its last default and now it is back again.
But we are more cautious of opportunities in Argentina. This is a country, that in the 200 years since independence, has defaulted seven times on its external debt and five times on its domestic debt.
If you look at the country, one of the most amazing things of 2017 was it managed to issue a 100-year bond.
Anybody who knows the history of Argentina knows that is actually quite a risky product and that it has already lost 20 per cent of its value.
So it can be a very interesting place to invest in, Argentina, with its very chequered history.
More broadly, I think a greater selection of stocks, a greater selection of countries is all good news.
Archie Hart is a strategy leader for emerging markets equity at Investec Asset Management.
