- Touchstone Investments believes that investors who are seeking growth should consider a portfolio overweight to Emerging Markets Equity. We believe there is low probability of a protracted trade war between the U.S. and China but think there will likely be intense downward pressure on equities – more so in emerging countries than in the U.S. – if this occurs
- We think it is likely that motivations to compromise will intensify as investors react to uncertainty and the U.S. elections approach
- We believe an Emerging Markets Equity overweight is important to consider due to attractive valuations and strong earnings growth based on our favorable long-term outlook
Touchstone has been advocating for an overweight exposure to emerging market equities based on what we believe are attractive valuations and strong earnings growth corresponding to increasing spending by a burgeoning middle class. Our views are nuanced regarding how to achieve such exposure. Going forward, we believe greater opportunities rest outside of China, but recognize that China is and will continue to be an important driver of the overall Emerging Markets story. Further, we believe Emerging Markets indexes are a poor means for allocating to the best opportunities that Emerging Markets countries have to offer.
Many are now asking whether an escalation in the trade war between the U.S. and China would derail our view on Emerging Markets. While we believe there is a low probability of it occurring, a protracted (greater than one year) trade war with the U.S. applying a 25% tariff on all Chinese imports – with the Chinese retaliating further – would certainly temper our enthusiasm. In such an environment, we believe equity markets in the U.S. and Emerging Markets countries are likely to suffer with Emerging Markets Equities declining more. We are already seeing evidence of how investors feel about trade relations uncertainty. If we see further trade talk deterioration leading to greater short-term concerns in equity markets, we believe both the U.S. and China will become even more motivated to find a compromise. China has more to lose in dollar terms but additional tariffs would directly impact U.S. consumers just as we enter election season.
Here's why our nuanced view is important. Among the goods the U.S. imports from China, little would be replaced with U.S. domestic production in the event of prolonged tariffs. As such, over time, that production would get sourced from other countries – most likely other Emerging Markets countries. Numerous U.S. companies have already stated that they have been creating contingency plans to source production outside of China. In this instance, lower exposure to China would be beneficial.
It is also important to note that the value of U.S. imports from China is overstated. In many cases, only the last stage of production (e.g., assembly) is performed in China but the full value of the product is reported. Investors may overestimate the tariffs impact on China based on product value rather than the portion that China contributes. Further, Chinese parts exported to other countries (e.g., Mexico) that eventually end up in the U.S. as a finished good would not be impacted by tariffs. As such, we would expect Chinese goods to find other paths into the U.S. We believe that tariffs are a blunt instrument and capitalism, like water, has a way of quickly finding the path of least resistance. These details suggest that the impact of Chinese trade may be overestimated by investors and the impact of tariffs on China may be lower than some trade flow data suggests.
Given that we do not anticipate a prolonged "worst case" trade war with China, we continue to believe in an overweight allocation to Emerging Markets Equities for growth portfolios. The near-term path may be bumpy given political rhetoric and complex negotiations. Much like the landscape in Japan in the 1970s, we think the tremendous growth in middle class spending in Emerging Markets, intermixed with capitalism and diverse cultures will lead to new business innovation and growth at a level that we are not anticipating here in the U.S.
The expressed views and opinions contained in this material are those of Touchstone's Global Market Strategist based on current market conditions and are subject to change without prior notice. There are no assurances that the opinions contained in this material will occur, this information is offered as a representation of a broad range of possible outcomes. This information does not take into account the specific investment objectives, restrictions, tax and financial situation of any individual client. Performance statements are historical. None of the information contained herein should be construed as an offer to buy or sell securities or as investment recommendations. This material is not intended to serve as the primary or sole basis for any investment decision. This information represents general market activity or broad based economic, market or political conditions and should not be construed as research or investment advice.
Investing in Equities, including International, Emerging and Frontier Market equities are subject to market volatility and loss. They also carry the associated risks of economic and political instability, market liquidity, currency volatility and differences in accounting standards. The risks associated with investing in international markets are magnified in emerging markets and frontier markets.
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