Unpacking Emerging Markets

Unpacking Emerging Markets

Over the coming few weeks, three topics will vie for the markets’ attention: the US November elections, surging Covid-19 infection rates in Europe and the US, and the results of the ongoing third quarter corporate earnings season.

We have addressed each of these three topics extensively in recent Market Compass pieces and will surely return to them over the coming weeks. But now, we’d like to draw attention to less-well followed developments in emerging markets and what they portend for investors.

Emerging markets are typically viewed by both investors and the media as a distinct asset class. The rationale is straightforward. Emerging markets represent faster-growing parts of the world economy, and precisely because they are ‘emerging’ (i.e., leaving behind troubled pasts) they typically demand higher risk premiums, reflecting weaker policy, political or economic institutions than their developed country peers.

However, it is easy to fall into the mental trap of believing that faster growth and a distinct emerging risk premium make for a cohesive asset class, one with a homogenous return profile.  By classifying emerging markets as a separate asset class, investors run the risk of ignoring fundamental differences among them.

The events of recent years—trade conflict, geopolitical risk and the Covid-19 pandemic—have laid bare that extreme differences exist among emerging economies, separating the best from the rest as regards emerging equity, fixed income and currency markets.

In the course of 2020, for example, the Chinese renminbi and Chinese equity market have turned in stellar performances relative to both emerging and developed markets. Year-to-date the renminbi has appreciated nearly 4% against the US dollar and a whopping 44% against the Brazilian real. This year China’s main equity index has thumped the S&P500 by some 13%, while outstripping Brazil’s equity index by more than 60%.

Indeed, a cursory glance at emerging equity and currency markets betrays a north Asian bias. Year-to-date emerging currency and equity gains are found in China, South Korea, Taiwan and India. In contrast, equities and exchange rates have slumped in Brazil, Russia, Turkey, Indonesia, Colombia, Chile, South Africa and Mexico.  Divergences in 2020 among emerging markets are significantly greater than between emerging and developed markets.

What explains the massive performance gap in emerging markets this year? One factor is public health, specifically pandemic control. With the exception of India, 2020’s basket of emerging winners is comprised of countries that have managed Covid-19 relatively well. Partly, successful pandemic control may reflect prior experience, for instance with SARS, that prepared their societies and public health institutions for more rapid and effective containment measures. As a result, countries such as China, South Korea or Taiwan have been able to sustain economic re-opening in ways the confounds other countries and regions, including much of western Europe and the US.

Financial strength is another factor. Larger, more diversified and higher income north Asian economies have been able mobilize economic and financial support more readily than poorer, more financially strapped emerging economies in Latin America, much of Africa or lower income Asian countries.

In contrast, the extent of a country’s open borders — as measured by trade’s share in GDP — is less relevant. India and Indonesia, for example, have similar shares of exports to GDP (roughly 19%). Yet India’s equity market has eked out a small 2% gain this year, while Indonesia’s has lost more than a quarter of its value.

Instead, the sector composition of exports (and national income) has been decisive. Less well diversified, raw materials producing or cyclically sensitive emerging economies such as Indonesia, Russia or Chile have turned in some of the worst equity or currency performance this year. That accords with the sharp underperformance in global equity markets of sectors such as energy or basic materials. Emerging markets with a strong presence in information technology, such as Taiwan or South Korea, have done much better.

Idiosyncratic risk remains important. Mexico, for instance, has languished not only because of exposure to underperforming industries such as energy or autos, but also because of its political, geographic and economic proximity to the US and attendant uncertainties unleashed by a more protectionist America.

Nevertheless, the mosaic presented by emerging markets this year resembles that of the broader 2020 investment themes. The best performing characteristics in global equities include reliable growth, underpinned by solid foundations. Cyclical exposure has lagged and cheapness (value) has extended a decade of underperformance. The same can be said about the relative winners and losers in emerging markets.

What broad investment conclusions can we draw for the period immediately ahead? If the US election results diminish political uncertainty and improve the prospects for sustained policy support to support economic recovery, and should pandemic risks recede, then investors will revisit the most beaten down emerging equities and currencies, just as they will see value in cyclically sensitive sectors elsewhere. But in the absence of more positive news, the emerging performance gap will remain large or even widen further.

Put differently, global risk premiums will dominate relative emerging market performance for the foreseeable future. Emerging markets are worthy of our attention. Emerging economies have much in common. But they have never been homogenous. Frequently, their differences matter more than their similarities. It may have taken the crises of 2020 to drive that point home, but it is a lesson that emerging investors shouldn’t soon forget.

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Unpacking Emerging Markets

Unpacking Emerging Markets

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