Emerging Market Stocks: the Revival of an Asset Class

As we all have watched with disgust, global equity markets were severely battered in 2018.  Investors who are positioned in emerging market stocks have suffered the most. This asset class plummeted by more than 10%. Large negative returns remain after converting exotic currencies back into Euro’s. In this article, I will first outline the stressors of the setback and then discuss the outlook for this asset class.

The underperformance of emerging markets can be mainly attributed to the tightening monetary policy of the US Federal Reserve. Last year, the difference in interest rates between the Eurozone and the US widened, as both regions follow a different ‘monetary normalization path’. It means that the US aims for higher interest rate growth, having the side effect of a stronger overvalued Dollar (see how this works in article ‘Why Investors Still Prefer One Euro Over a Dollar’). So…how is this of any importance for emerging markets? The answer is in the graph below.

As can be inferred from the graph, a stronger US Dollar happens to coincide with poor performance in emerging equity markets. The explanation is in the fact that a high US interest rate (strong Dollar) hampers economic growth, which in turn discourages imports from emerging markets. Emerging economies are usually more exposed to an adverse shock in demand due to their high degree of openness.

Next to economic growth effects, the higher interest rate and a stronger Dollar put a brake on global liquidity, which is a bad signal for high risk investments. It decreases investors’ appetite for emerging markets stocks. This appetite is further reduced  by investor concerns about US GDP growth, the lurking trade war and idiosyncratic risks (Turkey, Argentina). All of the above are influential stressors for the stock market decline in emerging markets.

Is there any potential for revival?

As with all asset classes, momentum changes when investors have reason to belief that risks decrease relative to potential returns. From a risk perspective, the monetary policy of the Federal Reserve is of great importance. After a long period of rate hikes, Fed Chairman Jerome Powell indicated in its recent speeches that the Fed will take a  break from further raising rates. Powell states that the US interest rates is very close to ‘neutral’ territory – a level that neither stimulates nor restrains economic growth. Given this statement, and the ECB rate hike plans (although not very convincing and decisive), the rate differential between both regions is likely to reduce. This limits risk for emerging markets.

China is struggling with adverse effects on growth due to slower trade.

In addition, there is political risk that affects the outlook for emerging economies. As one can imagine, a trade war between the US and China would have large consequences for emerging markets as they are particularly vulnerable to an impediment in global trade. However, there might be reason to belief that this concern will gradually shift to the background. The reason is that an aggressive trade war is not in the interest of both the US and China. Both countries will likely take a more constructive stance as they experience larger ‘costs’ than before. For the US, or president Trump in particular, re-election will become an important focus. In that light, the performance of stock markets turned out to be a crucial element in the measurement of his success. Given the immediate market response in US equity markets, ramping up tariffs takes its toll. Also from a Chinese stand point, a trade war will have large negative consequences.  China is struggling with adverse effects on growth due to slower trade. China’s economy grew 6.6% in 2018, its slowest pace in almost 30 years. The fight for preservation of intellectual property and technological rights thus comes with substantial collateral damage. As this applies to both countries, the odds of a trade deal increase. This dampens risk related to investments in emerging markets.

From a return perspective, the IMF recently published promising growth forecasts for emerging markets - especially when they are contrasted with forecasts for advanced economies. The IMF seems to expect that emerging markets stocks will be a good alternative in the course of time. Historically, the gap between growth rates in emerging and advanced markets has been a very strong driver of emerging market equity performance. As shown in the graph, the gap hasn’t widened since three years.

Moreover, whenever forecasts become reality, the current valuation level becomes a helpful companion in driving up stock prices. As a result of the recent loss in appetite for emerging markets stocks, the average P/E (price to equity) ratio dropped by as much as 30%. It reached a level that is significantly below the long term average. Although a similar development is observed for advanced markets, emerging market stocks are reasonably cheap on a relative basis.

What to take away?

The expectation that risks will reduce and investment returns improve for emerging market stocks is interesting, although caution remains. In the event of a US recession, emerging equity markets will definitely bottom out further before finding its way up. Fortunately, forward looking market data suggests a slowdown and not a meltdown of the US economy. A similar scenario, or even worse for some emerging countries, would arise if China fails to stimulate growth back to conventional rates. However, the odds that these risk materialize have recently decreased. It can thus be said that emerging equity markets are on the move towards the safe side of the risk-return spectrum.

Link 1 Link 2
Link 3 Link 4
Link 5