Why major EMs are undershooting the S&P 500
In the past 25 years, emerging market equities have returned in excess of 1,500 per cent in dollar terms, against a 430 per cent return from the US stockmarket, as represented by the S&P 500.
So why have the major emerging markets, which continue to be the engines of the global economy, underperformed the S&P so much in the past two years? The S&P has beaten the MSCI Emerging Markets index by more than 24 percentage points between July 2010 and June 2012, and outperformed China by almost 40 percentage points in dollar terms.
The fundamentals behind the appreciation of emerging markets equities are fairly well known: superior demographics, landmass, resources, as well as underpenetrated markets in banking, housing, services and consumption. All of this has been achieved on the back of improved governance and finances after the Asian and Russian crises of the late 1990s and the Latin American crises that culminated in Argentina’s default in the early 2000s.
Twenty-five years on, emerging markets are the biggest contributors and drivers of global growth and are a tailwind for US corporate earnings. Emerging markets’ underperformance has occurred in spite of fears of a slowdown in the US, a downgrade of its credit rating and the ongoing deadlock on fiscal issues. External factors such as the European debt crisis and concerns about a China ‘hard landing’ have not seemed to affect sentiment about the US. Investors are currently looking favourably on the fact the US has so far avoided a double-dip recession, alongside tentative signs of improvement in the labour and housing markets.
The fact China is growing at ‘only’ 7-8 per cent seems to be frowned upon. However, China has accumulated over $3trn (£1.9trn) in foreign currency reserves, and continues to run a current account surplus. Its total government debt to gross domestic product (GDP) does not exceed 8 per cent. May data showed China increased imports of copper by 65 per cent year-on-year, imports of pulp by 22 per cent year-on-year and iron ore imports by 20 per cent year-on-year. The Chinese government has cut rates twice in recent weeks, the first time since 2008, to address the issues of slowing economic activity. The Chinese have the ability to ease further as inflation pressures have subsided.
Apart from India, the major emerging markets are in strong macroeconomic shape, relative to their own history and certainly relative to the US. The recent underperformance of emerging market indices is hard to justify by fundamentals.
The answer to the recent outperformance of the S&P over emerging markets could lie in liquidity. The Federal Reserve’s asset purchase programme since 2009 injected liquidity into markets that were starved of money and has been accompanied by a continued rise in the S&P. But these injections peaked in 2009, while ever since 2010 Europe’s snowballing debt crisis has dominated the headlines. As a result the euro has been losing ground against the dollar. Emerging markets also suffered net outflows of $30bn since December 2010.