This should be a horrible environment for emerging markets. The dollar is high, investors are risk averse and global inflationary pressures hit weaker economies harder. However, in the current volatility, emerging markets have fallen less than developed markets. What is behind this apparent anomaly?
The MSCI emerging markets index is down 17.63% for the year to June, compared to a drop of 20.51% for the MSCI World. This surprising ‘outperformance’ has mostly come over the last three months, propelled by a resurgence in China, which has started to peak investor interest once again.
However, it is a very mixed picture: Russia is uninvestable, Latin America appears to be losing its commodities ‘bonus’ from the start of the year and eastern European markets are vulnerable to Russia switching off its natural resources.
Collective funds have done slightly better than the index, supporting the view that these are stock-pickers’ markets. The average fund is down 11.5%, year to date.
Geographic positioning has been important. Some funds have had to write down their Russian holdings to zero and any overweight positioning in eastern European markets more generally has been punished.
In contrast, those funds that reinvested in China at the right moment have made hay – the average China/greater China fund is up 10.3% over the three months to 28 July, according to Trustnet.
S&P warns of slower growth despite Q1 surprises
It is difficult to make a good case for emerging markets on economic grounds.
Oxford Economics said in a recent report on the sector: “EMs look vulnerable to a potential recession in advanced economies as global demand and trade slow. Higher inflation is eroding consumer spending. Meanwhile, higher interest rates, slower credit, and collapsing equity markets have all contributed to tighter financial conditions, threatening investment. This backdrop supports our view of a stronger-for-longer dollar.
“Typically, a stronger dollar hurts EMs through several channels, including balance sheet and deleveraging effects. Indeed, EM financial conditions continue to tighten and are close to getting as tight as they were at the peak of the Covid crisis.”
S&P Global Ratings also recently lowered its real GDP growth forecasts for emerging markets to 4.2% in 2022 from 4.8% in March, triggered by a weaker forecast in China.
Excluding China, there were growth surprises in several emerging market economies in the first quarter. But it added: “Risks to baseline growth forecasts remain squarely on the downside.”
Eastern Europe and parts of the Middle East are particularly vulnerable. S&P said: “The Russia-Ukraine conflict is taking an increasing toll on emerging Europe, while several commodity-importing economies in Middle East/North Africa (Mena) are among the hardest hit by spillovers from the conflict. Mena energy exporters are enjoying windfall revenues, but slower global growth and tighter financing conditions will moderate these gains.”
Emerging markets have an established playbook for taming inflation
From here, emerging markets have some small advantages. Flavio Carpenzano, fixed income investment director at Capital Group, points out: “There is reason to be optimistic about the future of emerging markets. Indeed, many emerging markets central banks are well ahead of the Fed in terms of hiking rates to rein in demand in their economies to try to tame inflation.
“As emerging markets economies tend to be smaller, less economically diverse, and more reliant on exports and imports, inflation is a much more prevalent issue in these markets. Where developed markets are scrambling to address inflation that hasn’t been seen in many decades, many emerging markets have an established playbook for how to rein in inflation domestically.”
Anthony Willis, investment manager in the multi-manager team at Columbia Threadneedle, points out that rapid monetary policy action has helped protect many emerging markets from the worst effects of a stronger dollar.
“Gains seen in the dollar have been stronger against developed market currencies, while emerging market currencies have held up better,” he says.
Improving backdrop for China and India
That said, with Russia out of action and Brazil’s commodity windfall drawing to a close, India and particularly China need to do the heavy lifting.
China’s Caixin service Purchasing Managers’ Index (PMI) reading for June was 54.5, a strong rebound from May’s reading of 41.4. Investors continue to fret about the impact of renewed Covid lockdowns, but the country is charting a path out of lockdowns.
Victoria Mio, director of Asian equities at Fidelity International says: “We think the situation is largely under control. Vaccination rates continue to rise.”
She believes China’s economic prospects are encouraging: “The world is facing an economic downturn, whereas China is a different stage in its economic cycle. It is re-emerging from serial Covid lockdowns and this supported a stock market rally in June.”
Mio says the elephant in the room is property. However, the Chinese authorities are taking action to ringfence recent property scandals and defaults, and restore confidence.
She adds: “Current mortgage issues may delay the recovery, but will not translate into any systematic risk. The property market Is likely to recover in the second half of the year.” She points out that retail sales are recovering and confidence is also starting to pick up.
“It won’t be a straight line recovery or a significant acceleration. That stimulus still needs to work through and this will take time. But the backdrop has improved substantially.”
It is a similar picture in India. The IMF has recently slashed its growth forecast for the country by 80bps to 7.4%.
However, it is still showing faster growth than any other major economy, creating a fertile environment for companies to grow earnings. It has the headwinds of raising rates, but looks relatively strong compared to other emerging and developed markets.
Over the past decade, emerging markets have delivered an annual performance of 3.1%, compared to 8.8% for developed markets (source: MSCI to 30 June). This has left emerging markets and their currencies looking cheap. With expectations so low, it only takes a few marginal buyers to move the dial.
Emerging markets are further through their rate hiking cycle than developed markets and may be better able to weather inflationary pressures. While it would be brave to call the bottom of the market, we may be closer to the end than the beginning.
