The underperformance of emerging markets is making investors nervous, but understanding the situations that threaten emerging markets will help manage investor angst.
According to William Blair portfolio manager of Emerging Markets Strategies, Todd McClone, the characteristics of emerging markets gives them reactions to global economic change which are different to other asset classes, and therefore the impact on them is unlikely to be as simplistic as ‘chicken and egg’.
“A headline such as ‘End of the commodity boom’ is daunting to investors, but when you understand what this means for emerging markets, you can see they have unique traits that may in fact reduce or further explain this impact so that investors don’t become underweight to the sector.”
For example, Mr McClone says there are several explanations as to why the end of the commodity boom does not spell doom for emerging markets, including the fact that the impact of commodity sectors on emerging market equities has virtually already played out.
“The energy and materials sector weights in the MSCI Emerging Markets Index are now only at 13 percent, down from 38 percent at the peak of the commodity boom and almost on par with the MSCI World Index,” says Mr McClone.
Secondly, despite conventional wisdom that says falling commodity prices are negative for emerging markets, the reality is there are far more emerging markets that are beneficiaries of weaker commodity prices than those that are not.
Finally, the general perception that emerging markets and commodities are highly correlated is too simplistic. Mr McClone says it is true the correlation between commodity prices and emerging market equity prices significantly increased from 2005 to 2013, however this actually benefited commodity-producing countries in emerging markets and drove a general optimism regarding the asset class.
“It was a sort of rising tide that lifts all boats, not just emerging markets and drives correlations higher.”
Mr McClone says the state of the Chinese economy is another headline which is causing undue concern. He says the largest parts of the Chinese economy (the service- and consumer-related sectors) are strong while the weaker parts are showing signs of stabilization. In addition, the much-feared residential property market has been on a path to recovery for several months, responding well to stimulus measures taken late in 2014 and early 2015.
“We believe investor expectations of further devaluation have been overly bearish as four factors do not seem to support a competitive devaluation argument: China’s record 2015 trade surplus of $600 billion, the health of the Chinese consumer, the absence of unemployment, and China’s relentless rising market share of global exports.”
Getting the full picture also means understanding disappointing economic growth in emerging market countries, which although it has declined, this is relative to developed markets.
“This [factor] is important because research shows relative GDP growth rates are a key factor in determining outperformance of emerging versus developed markets,” says Mr McClone.
Another area of concern for investors is the potential impact of U.S. interest-rate hikes and a stronger US dollar. However, Mr McClone says an analysis of historical Fed tightening cycles since 1969 shows that emerging markets have outperformed developed markets during most such cycles.
“The only exceptions occurred when tightening cycles were considered “violent”—that is, the rate increases came sooner than the market anticipated or were stronger than the market anticipated, or both,” he says.
Mr Mr McClone has authored a White Paper: What Has Everybody Been Worried About? A Closer Examination of the Angst Surrounding Emerging Markets
