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Emerging markets: An update

Emerging market stocks are lagging behind those in developed economies by the most since 2013’s “taper tantrum”, having ended the third quarter of 2021 down 8.1%, the worst quarter since the first of 2020 when Covid-19 hit. On the year, MSCI’s Emerging market (EM) index is basically flat, in stark comparison to the Developed market (DM) index which has seen returns of more than 20%. Bond prices in emerging markets have similarly struggled. With Federal Reserve plans to reign in US stimulus, there are concerns that market conditions could deteriorate further just as they did in 2013. 

A brief summary of performance

Graph by Refinitiv.

As outlined, the performance of EM equities has severely lagged behind that of DM. Their performance in Q3 2021 was particularly disappointing having finished the quarter down 8.1%, the index’s worst quarterly performance since Q1 2020 when the pandemic first hit. This performance was also consistent across most industries: only energy, materials, IT (negligible), financials, industrials and utilities have seen a positive year to date performance. Consumer discretionary equities, real estate and communication services were down as much as 15-20% for the year. 

The fall in the prices of EM bonds has nested the appeal of the higher interest they offer. JP Morgan’s index for tracking debt issued in local currency is down 8.1% for the year in US dollar terms. Corporate debt in EM were among the best performers in the EM debt asset class, whilst hard currency sovereign bonds were among the worst performers, according to Lazard Asset Management.

Causes

Such a poor performance relative to DM contrasts historical performance as figure 1 shows. This therefore begs the question, what are the reasons for this divergence? 

China

The sell-off in Chinese assets can be attributed to much of the declining performance in EM equities, particularly in Q2 and Q3 of 2021 (particularly indexes like the MSCI EM that include China). As has been covered by other CIBS articles, the speed and severity of China’s regulatory crackdown on private companies escalated hugely across 2021: An investigation into Alibaba resulted in a $2.8bn fine, forcing restructuring by Ant. Other probes and fines for other high profile internet-platform, video gaming, education and Macau casino companies soon followed. 

Investors are now increasingly searching for EM funds that steer clear of China. The assets of five prominent EM exchange traded funds excluding China surged 41 per cent to $1.5bn during August, taking their year-to-date growth to 442 per cent, having ended 2020 with just $277m between them.

Therefore, indexes, like the MSCI EM index, with exposure to Chinese equities have underperformed. 

Growth forecasts

While estimates for 2021 global growth remained steady at 6% in the third quarter, expectations for 2021 and 2022 have fallen for EM. This can be attributed to severe delays in vaccination against coronavirus and renewed lockdowns in face of the Delta variant.

The greatest reason perhaps for investing in EM equities is that they offer higher rates of growth than DM equities, in turn providing investors who are willing to take on greater risk, with superior returns. Perhaps the single most-watched indicator of projected returns on EM assets is the GDP growth differential between emerging markets and developed markets. As figure 2 shows, the growth differential between EM and the US for example, is forecast to be lost.

Graph by BofA Global Research

Inflation

Persistent and rising inflation remains an issue for many developing economies. Emerging-market consumer price index baskets are more heavily weighted to volatile food and energy prices. Together with developing markets’ decisions to tighten fiscal policy which weakens EM currencies, inflation becomes an issue. This is particularly the case for high importers of energy like Turkey or India, as opposed to exporters like Russia or Nigeria. This threat of inflation has pushed bond prices in EM down. In response to this, many policymaker have made decisions to push up interest rates, which in turn affects growth prospects and equities:  Russia has pushed rates from 4.25 per cent to 6.75 per cent this year, Brazil, from 2 per cent to 6.25 per cent, and Mexico, from 4 per cent to 4.75 per cent.

Luis Costa, an emerging markets strategist at Citi, has illustrated the difficulty this now causes for EM investors and policymakers alike: “Any EM asset class — equities, currencies, debt — is based on one important assumption. You rely on growth.. So it is an issue that banks have been hiking… It is very tricky for central banks because the growth picture is not rosy, it’s not the second half of 2020, but they may still have to hike faster. You cannot afford losing control of inflation.” 

The outlook 

However, the outlook for EM assets is certainly not all bad, with vaccination pickup and rollout in many nations improving. Whilst growth estimates for the rest of 2021 remain negative, IMF estimates for EM growth in 2022 is stronger at around 5%, albeit still lower than growth rates of the past. The MSCI predicts that earnings growth in EM in Asia will lead the world at almost 10% growth for the year. Meanwhile, Lazard Asset Management believes that the risk of US tightening of monetary policy, which would impact EM bonds and equities, is not too great, as rates hikes are a long way off, bond purchases by the Federal Reserve will only be slightly trimmed initially and EM recovery will thus not be derailed going into 2022.  

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