In the first half of the year emerging market debt and equity asset classes were up low to high single digits in benchmark indices, and combined fund flows were positive at around $40 billion, as early year euphoria gave way to solid performance expectations. Several months ago global investor surveys had the category as a runaway favorite versus developed markets, on the assumption the world’s major central banks would only marginally tighten liquidity, and the two largest economies the US and China could resolve trade and investment disputes over time. Developing market growth was projected at 4-5% on subdued inflation, as bank and non-bank deleveraging s continued after years of double-digit credit expansion. These trends remain largely intact with modifications for monetary pause or easing, as the decade-long cyclical recovery fades with additional tariff and non-tariff barrier drag for competitive and security reasons.
Fund managers are comfortable with these scenarios, but admit that the prospect of emerging market currencies, which almost all fell against the dollar over the period, in the negotiating mix is an unprecedented allocation variable. The US Treasury Department has China and its Asian neighbors on a watch list for possible “manipulation” inviting retaliation, and an understanding was written into the new free trade pact with Mexico. The coordinated system established under Bretton Woods fell apart forty-five years ago as the institutions created then, the International Monetary Fund and World Bank, mark their 75th anniversary under leadership and mission transition affecting foreign direct and portfolio investment flows. The main index providers for core and frontier stocks, and local and external corporate and sovereign bonds, are also in reinvention mode to upset traditional practice, especially as passive exchange traded funds eat into active manager business. MSCI, at the same time it added Chinese “A” shares and Argentina and Saudi Arabia to the core market roster, issued a paper for the index’s 30th year of operation mulling future yardstick change.
The trade and supply chain threats under the Washington-Beijing standoff have been brewing for years, with most emerging economies promising to diversify the export-led growth model and forge new cross-border relationships. Investor preference now is for strong domestic consumption and investment stories, especially if the latter is private and for long-term infrastructure purposes. Vietnam is a popular Chinese assembly and manufacturing backstop since it stayed in the Trans-Pacific partnership despite Trump administration exit and just finalized a deal with the European Union. The EU, in turn, after decades of talks just reached a pact with Mercosur members Argentina and Brazil. Africa has generated excitement with ratification of a continental free trade zone, also envisioning small stock exchange integration.
These arrangements avoid currency questions that could imminently feature not only in the context of goods and services flows, but as historic dollar dominance and recent sanctions promote parallel channels. China and Russia within their own regions and the broader BRICS grouping intend to develop pure emerging market reserve pools for diplomatic and monetary protection. China was included in the IMF’s Special Drawing Rights basket, and other emerging markets have pressed for modification in standard criteria so they can be added on the way to a usable unit reflecting their share.
Portfolio managers into the second half of this year must also brace for reconstitution and consolidation of the multiple gauges for public asset classes, as private ones also enter the fold. MSCI acknowledges that its core benchmark is too Asia-driven, and JP Morgan has unified external corporate and sovereign listings, as it considers dropping heavyweights like South Korea from the former. Sponsors are working to develop hybrids mirroring multi-asset strategies, including for private equity without an existing measure. While the so-called trade war may soon trigger currency revolution, an internal industry one will equally shape near-term performance.