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2018, a challenging year for global markets, was driven by macro-related factors in the form of contracting U.S. dollar liquidity, a rising U.S. dollar, trade conflicts, and a slowdown in global growth, especially in emerging markets’ largest economy, China. After a euphoric start for the year, volatility spiked as inflation fears in the U.S. strengthened the case for higher rates. Global trade renegotiations (NAFTA, Eurozone, and China) also added fuel to the fire. The market saw the start of what can be described as a Thucydidean1 conflict between the U.S. and China over trade and ever increasing fears of a Chinese economic slowdown.
In the midst of it all, we continue to believe that the real story in emerging markets remains the long march of secular growth. Despite the vicissitudes (which we have seen before many times) of the market this year and quarter, we remain confident in our companies. We invest for the long term, and in the long term, we believe, markets always come back. As far as we are concerned, we can report that in our opinion some of the world’s best structural growth expressions may be selling at a discount.
Moving on to the fourth quarter: Despite having another negative quarter, we were encouraged by the performance of the emerging markets asset class. The MSCI emerging markets index held up relatively well compared to global equities, outperforming the S&P 500 by almost 6%. Small caps in emerging markets outperformed large caps while growth stocks continued to lag behind value stocks. Utilities and real estate sectors performed best during the quarter. Healthcare and consumer discretionary declined most. On a country level, Brazil and Indonesia performed best while Pakistan and Colombia lagged most.
The year ended on a positive note delivered by the U.S. Federal Reserve as it expressed patience in terms of the path of interest rates in 2019. The dispute with China remains. However, we have seen some signs of progress in trade negotiations during the fourth quarter and into 2019, which is helping to relieve some pressure off emerging markets. Having spent the first six months of the year in a tightening “stance”, China spent the second half of the year, and the fourth quarter in particular, shifting to a more expansionary policy position, not least to address the development of its trade conflict with the U.S. Slowly, but surely, it started to introduce “drip irrigation” measures on three fronts: fiscal, monetary, and regulatory. In addition to trade, as the year drew to a close, the Chinese administration faced a further two issues: 1) safeguarding its property market (some 30% of Chinese personal wealth is in property) from damage as policy changed; and 2) repairing the transmission mechanism of its monetary policy. In regard to this last, the issue is not one of liquidity, but rather the fact that funds continue to flow to state owned enterprises (SOEs) as opposed to small and medium-sized and/or private enterprises where it is needed more for monetary policy actually to be effective.
Together with continuing to face the challenges of exiting a brutal recession, in the fourth quarter, Brazil had to deal, in the form of presidential elections, with increasingly loud domestic political “noise”. Elections over, there is now cautious optimism on the political front. It is generally acknowledged that the new Brazilian president, Jair Bolsonaro (elected at the end of October and sworn in on January 1, 2019), has not only created an excellent cabinet team, but has also advocated a mostly business-friendly agenda. However, whereas immediately after the elections, expectations were high for speedy reforms, these have been tempered by the realization that they are not a “done deal” and the government will have to negotiate with Congress. India is now in the election phase. Populism has surfaced as a risk, adding to that of the ailing public banking system, which is in dire need for recapitalization in order to restart the investment cycle.
Looking forward, there are plenty of reasons to be optimistic in 2019. First, and most importantly, it is hard to make a strong case for the U.S. dollar in 2019 in the face of a slowdown in rising U.S. rates and expanding U.S. twin deficits. Second, a couple of potentially positive developments on the China front: The stimulus, which continue to be injected by the Chinese government, we believe will find its way to the economy shortly, halting in the process the slowdown, which has begun to eat away at the country’s economic growth. Furthermore, the reported progress in the U.S./China trade talks has been encouraging thus far, but the events of the past year dictates that we remain cautiously optimistic that a deal will be struck before the 90 day deadline. Third, valuations in emerging markets are currently below the asset class’ long term average and at a multi-year low compared to the S&P 500. The picture is not all rosy. We may see further downgrades in earnings of emerging markets companies in 2019. Also, a resumption in the trade war between China and the U.S. can also be damaging, at least to sentiments.
IMPORTANT DEFINITIONS AND DISCLOSURES
1Thucydides, the ancient Athenian historian, when describing Athens’ conflict with an aspiring Sparta in his History of The Peloponnesian War said: "It was the rise of Athens and the fear that this inspired in Sparta that made war."
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