Emerging-market equity investors are likely happy to bid goodbye to 2018—a year filled with challenges and uncertainties. Chetan Sehgal, Franklin Templeton Emerging Markets Equity’s director of portfolio management, examines some of these challenges and uncertainties, and makes the case that investors may have been overreacting. He says many emerging markets were unjustifiably priced for crisis-type situations.

In 2018 the world economy—and global relations—entered unfamiliar territory, with rising geopolitical and policy risks. We are witnessing the global supply chains and trading relationships that have been integral to growing global prosperity come under increasing pressure. Thus far, emerging markets (EMs) appear to have borne the brunt of the fallout: an asymmetric—and, in our view, excessive—market reaction that has contributed to valuations at near crisis levels by November 2018. However, these are valuations that to us represent increasingly attractive buying opportunities, given where fundamentals stand.

What Are Markets Anticipating?

There has been a substantial divergence in performance between EM and US equities during 2018, on a scale that we find challenging to justify. While the United States has benefited from the one-off, near-term impact of tax cuts and repatriation of overseas profits, this impact is expected to sharply fade in the coming two years, which is forecast to result in widening EM outperformance in terms of economic and earnings growth. The International Monetary Fund sees EM economic growth in 2019 holding steady at 4.7%, while it has forecasted growth in advanced economies to slow from 2.4% in 2018 to 2.1% in 2019. Additionally, estimated EM earnings growth of 10.5% in 2019, while below projections of 15.4% for 2018, would nonetheless compare favorably with estimated US earnings growth of 9.5% for 2019, down from 21.2% for 2018.1 On a forward-looking basis, we believe current fundamentals do not warrant the declines seen in EM assets over 2018. And while investor expectations may deteriorate, we think the gap between EM fundamentals and valuations is such as to provide a reasonably large margin for performance potential.

Trade tensions have been a primary contributor to weakness in EM equities, and while exports remain a key engine of growth for EMs, they are increasingly shipped to other emerging economies; the relative importance of developed markets has declined. Similarly, the roles of consumption and technology in generating economic growth have become more prominent; EMs have become more domestically orientated. While tariffs undoubtedly come at a challenging time for China as it seeks to deleverage its economy, the impact will also be felt globally—recent US corporate earnings announcements and concurrent equity market volatility are testaments to this. Politicians may yet conclude that trade wars are not easy to win.