Stockholm (Ekonamik) – 2018 was a disappointing year for almost all financial assets, but emerging market equities in particular felt the pain. The MSCI Emerging Markets Index retreated 14.6% last year versus the 8.7% decline for the MSCI World, with the sell-off in emerging markets caused by a strong US dollar, a tighter monetary policy embraced by the US Federal Reserve, concerns of an economic slowdown in China, and an escalating trade war.
As has been the case for a while, emerging market equities are underperforming global equities so far this year as well, so the question of which factors are affecting the emerging market performance remains relevant.
Trade War and Tightening Financial Conditions
Whereas a wide range of factors may be driving the performance of emerging market assets, most seem to agree that the rising trade disputes and the US monetary policy are the two key factors determining where emerging market assets are heading. Michael Levy, Co-Head Emerging and Frontier Equities at Barings, said in May that “the correction in equity markets last year reflected investor concerns regarding the US Federal Reserve’s tightening, and the potential implications for EM countries, especially those with current account deficits.” Levy further argued that “rising trade tensions between the US and China also contributed, raising questions on global growth.” In his opinion, “these two factors led investors to demand a higher risk premium for investing in EM equities.”
In late January of this year, Jeff Shen and Gerardo Rodriguez of BlackRock downplayed the role of rising trade tensions in the performance of risky assets in emerging markets, arguing that “the main problem that financial markets have faced has to do with the significant tightening of financial conditions due to the combo of Fed raising rates, credit spreads widening, the USD strengthening and equity markets falling.” Many corroborate the BlackRock duo’s argument that tightening financial conditions do affect the performance of emerging market assets.
Stephanie Rowton, a London-based Investment Strategist with Allianz Global Investors, wrote in late May that the tightening monetary policy by the US Federal Reserve “was a major headwind for emerging markets, which have historically suffered when foreign direct investment is drawn back to less-risky US securities.” Besides, “cheap US debt also helped the finances of many emerging-market countries, which may in turn have trouble paying down that debt in a rising-rate environment.”
Just as Shen and Rodriguez argued, historically, a strengthening US dollar has also strongly affected emerging market assets. Thomas Verbraken, a member of MSCI’s Risk Management Solutions research team, and his colleagues conducted a stress test to assess the vulnerability of emerging market equities (excluding China) and debt through their sensitivity to the US dollar versus a trade-weighted basket of non-U.S. currencies. MSCI’s stress test “shows that this relationship was consistently negative over the past decade,” implying that “as their correlation was persistently negative, EM debt and equity generally took a hit when the USD strengthened.”
The Escalating Trade War Increasingly Weighting on EM Assets
Whereas BlackRock might have downplayed the impact of trade tensions on emerging market assets at the beginning of the year, a trio from BlackRock – Elga Bartsch, Ben Powell, and Scott Thiel – wrote earlier this June that “rising trade disputes and U.S.-China strategic tensions are increasingly weighing on global risk assets” including emerging-market assets. The trio also wrote that “the rising U.S.-China rivalry is casting a cloud over China’s growth outlook.” Torje Gundersen, head of allocation and selection at DNB ASA, said in a recent interview that “emerging markets have been beaten up because of the trade conflicts.”
A slowing Chinese economy could have repercussions for other countries as well. “The more pressing concern is what the escalating tensions imply for the sustainability of global supply chains – and for both Chinese and global companies that rely on them,” wrote the BlackRock trio this month. Verbraken, at MSCI, and others agree, with Verbraken writing in late May that “a further escalation of the U.S.-China trade war could have severe implications for the Chinese economy with potential spillovers to other EM countries.”
In another stress test performed by Verbraken and the team at MSCI, the results show that “a slowdown in China could affect many EM countries, in particular commodity exporters. Indeed, when gauging the correlation between EM equity (excluding China) and debt and the Chinese equity market, we see that, historically, EM debt and equity have usually declined when Chinese equities dropped.”
In a June article, Unigestion showed some evidence that “the trade war has weighted on emerging equities more than on developed ones.” The chart below displays the annualized average return of major indices over the period of 2018-2019, comparing only days following negative trade war-related announcements (dark blue) with the annualized return of each index over the same period (grey). According to the Unigestion article, “since 2018, days with negative trade war announcements led emerging equities to underperform their developed counterparts by about 20 basis points per day.”
Indeed, several factors weighted significantly on emerging market assets in the recent past, but recent headwinds may soon turn into potential tailwinds for emerging markets. William Palmer, Co-Head of Emerging and Frontier Equities at Barings, argued in May that the risks associated with the US Federal Reserve’s tightening and the trade tensions between the US and China “have fallen in the last few months.” He suggested that “the reversal of these former headwinds into potential tailwinds have been a significant driver of markets so far this year” and have the potential to serve as tailwinds going forward.
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