The bulls return to emerging markets

The bulls are charging back into emerging markets. The MSCI Emerging Markets index has lagged so far this year, gaining 6.8% to the developed world’s 11.7%. Yet last month it outperformed developed markets for the first time since January, says Bloomberg. The commodity boom has powered the latest rise: materials and energy make up 14% of the MSCI EM index, compared with 8% for the developed market gauge.

Global money managers pulled $44bn from emerging markets during the first half of 2020, says Jonathan Wheatley in the Financial Times. But they have since returned in force, pouring more than $100bn into emerging equities and bonds during the nine months to 31 March.

Covid-19 blues

An emerging-market economy is one that is moving “from low-to-middle income to high income”, explains Fidelity International on thebull.com.au. The benchmark MSCI EM index is diverse, including east Asian tigers, giants such as India and Indonesia and commodity exporters such as Russia, Brazil and South Africa. Chinese shares make up more than one-third of the index.

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Emerging markets are distinct from “frontier” economies, says Fidelity. Many countries in Africa, eastern Europe and the Middle East are classified as “frontier”. Vietnam is still generally considered a frontier market too, despite its strong economic potential.

What distinguishes emerging markets from frontier ones is that the former have “some of the characteristics of a developed market”, such as “a functioning stock exchange where shares can be easily traded… and some form of predictable government regulation – all of which help smooth its path to development”.

A surprising rebound

The recent pick-up in emerging-market shares is a surprise because the near-term economic backdrop has darkened. The centre of the pandemic has moved towards Latin America and India. The International Monetary Fund has warned of a “great divergence”, where unequal vaccine distribution means “rich countries recover strongly while others flounder”, says Kaushik Basu on Project Syndicate.

The World Bank, meanwhile, estimates that the pandemic has pushed “up to 40 million people in Africa into extreme poverty”. The virus is also putting strain on government budgets; “some, like Zambia and Argentina, have already defaulted”.

A new taper tantrum?

Things were not looking that great even before the pandemic.’ Per capita, “growth in emerging markets ex-China has been below developed markets since the mid-2010s”, say Udith Sikand and Vincent Tsui of Gavekal Research. Meanwhile, recent US Federal Reserve minutes show that policymakers have tentatively started to discuss cutting back their programme of $120bn of monthly bond purchases, known in the jargon as a “taper”.

In 2013 expectations that the Fed might be about to do the same triggered the “taper tantrum”, a “traumatic sell-off in emerging market assets and currencies”.

Tighter US monetary policy is usually bad for emerging markets. Higher interest rates in America can encourage investors to pull cash out of traditionally risky assets and park it in the world’s biggest economy. Tapering also strengthens the dollar, which raises financing costs for businesses that borrow in dollars but earn their revenue in local currency.

A global boom bodes well

A long period of ultra-low interest rates means many investors have put their money in emerging markets simply to get a decent yield, says Chris Dillow in Investors’ Chronicle. That money will quickly flow back to developed economies should interest rates rise. Still, an outright repeat of the 2013 taper tantrum looks unlikely. “Since 1991 there has actually been a slight positive correlation between annual changes in the [benchmark US interest rate] and MSCI’s emerging-markets index.” The Fed usually hikes rates during times of economic confidence. Boom times bring more risk-taking and that sends plenty of investors hunting for returns in emerging markets.

Choose carefully

Valuations look appealing too. The MSCI EM index trades at 14 times forward earnings, a discount to the average of 20 across developed nations, according to Bloomberg. And the long-term outlook for emerging economies remains auspicious, says Fidelity. The median age in India and South Africa is 28, compared with 41 in the UK. Those populations are also getting richer. China’s middle class is expected to represent 73% of its population by 2030, compared with 10% in 2009. That means structural growth in demand for everything from consumer goods to healthcare.

Come 2050, emerging economies should account for 58% of global GDP, compared with 45% today, says William Jackson of Capital Economics. The winners are likely to fall into one of three groups: countries in sub-Saharan Africa, which will enjoy demographic-driven growth in their workforce; economies in Asia, north Africa and Mexico, which have a solid manufacturing base; and Chile and Peru, whose copper exports will be in strong demand for the green transition. There will also be underperformers. Parts of east Asia and eastern Europe are ageing fast. South Africa and other parts of Latin America may also lag behind.

British investors are reportedly opting for China-focused investments over the likes of “problem-hit Brazil” and other “economies that were foundering before the coronavirus crisis”, says Wheatley. Given their divergent performance, it has never been more important to choose your emerging markets wisely.