Beyond tapering: Divergent emerging market trends

Just over a year ago former Federal Reserve chairman Ben Bernanke signalled in his testimony to the Joint Economic Committee that it would to scale back asset purchases, with the bank finally moving reduce the programme by $10bn from January of this year.

The policy may have been domestically driven, but the scale on which the stimulus had be routed to Asia was revealed by the sell off that followed the comments - before any tapering had even taken place.

From May 2013 to the end of the year the MSCI Emerging Markets index saw a drop of 11.72 per cent, having previously recorded gains of 8.22 per cent in the first five months of the year, according to FE Analytics.

Markets have been more benign since the policy was brought into action, the effects having by now been priced in, but growth remains sluggish as emerging markets broadly continue to lag larger developed peers.

The MSCI Emerging markets index has largely been in negative territory since the turn of the year, in January alone losing roughly 7 per cent. However, the tide seems to be turning with the index currently in positive territory for the year to date to May 30 with a return of 3.53 per cent.

But with such a diverse region the overall index performance does not necessarily show the whole picture and in particular which countries are performing better or worse than the others, particularly with so many macro events taking place in these markets.

In short: tapering was the headline issue last year, but there is now a variety of trends across the main emerging markets.

Russia

The most obvious example is Russia. One of the core Bric countries, it is nevertheless had a difficult time compared to its better performing peers China and India.

In 2014 the situation has been made more volatile with the situation in Ukraine, especially following the sanctions that have been imposed in the wake of the annexation of Crimea.

Russian GDP growth at 0.9 per cent in the first quarter of 2014 is down significantly from the 2 per cent recorded in the last quarter of 2013. The economy could grow as little as 0.5 per cent this year, Prime Minister Dmitry Medvedev has admitted.

And the fallout from the Ukraine crisis has hit stockmarket performance, with even a strong rally over the past month leaving the MSCI Russia index 9.51 per cent down for the year so far to 30 May. This compares to the MSCI India return of 15.79 per cent, the MSCI Brazil index return of 6.94 per cent, and the smaller MSCI China index loss of 4.93 per cent.

For the five years to May 2014 the MSCI Russia index has delivered a disappointing 15.8 per cent, while for a three-year period it recorded a loss of 23.51 per cent. The only market to deliver worse returns was the MSCI Brazil index.

China

China’s apparent slowdown has obviously been a continuing theme that accounts for the reluctance of investors to return to emerging markets, but there remain signs of hope as the country continues to take steps to develop a large and efficient domestic bond market.

Jan Dehn, head of research at Ashmore, explains: “Ten local governments were given formal permission to begin to issue their own bonds.

“The local government administrations of Shanghai, Zhejiang, Guangdong, Shenzhen, Jiangsu, Shandong, Beijing, Qingdao, Ningxia, and Jiangxi will now issue bonds within quotas approved by the central government. The bonds are fixed coupon bonds with 5, 7 and 10 year maturities.

“The bond market is going to be the main transmission mechanism for monetary policy as the government shifts China’s growth model from an export-led to a domestic demand-led footing. Local government bond issuance is likely to grow rapidly in the future, increasingly replacing less transparent local government financing vehicles and bank loans.

“Transparent bond financing introduces market discipline to harness errant administrations by pushing up their borrowing costs. Bonds will also provide an important alternative asset to equities and property in the portfolios of China’s savers – as bonds will help to stabilise these savings pools over the business cycle they will reduce the precautionary savings motive and thereby help to boost domestic consumption.”

India

It is not just China where momentum is changing, with the recent election of Narendra Modi as prime minister and the appointment of a new finance minister in the form of Arun Jaitley, there is expectation that the change of government will result in reforms to India’s economy.

The latest GDP figures for India in Q1 were slightly below expectations at 4.6 per cent, which is the eighth quarter with less than 5 per cent growth. Craig Botham, emerging markets economist at Schroders, notes the figures emphasise the need for a policy overhaul from the new government.

He says: “The recent appointment of Arun Jaitley as finance minister is a positive sign, but there are no quick fixes to structural problems. All new appointees have made the right noises so far, but July’s budget is the first chance to offer real concrete commitments to reform. A reduction in subsidies would be a good start.”

Brazil and beyond

Elections are also a potential gamechanger in Brazil, which although it has performed positively in 2014 so far in terms of GDP growth remains below forecast with a Q1 figure of 1.9 per cent.

Mr Botham notes: “With investment also contracting 2 per cent year-on-year, the need for a change in policy is increasingly evident. Bottlenecks play a large role in driving Brazil’s inflation, now running close to the top of its target band, and it will be difficult to tackle without addressing supply side concerns.

“This data will only spur investor desire to see President Dilma Rousseff ousted in October’s elections.”

Fund performance

Perhaps not surprisingly in such an uncertain economic environment the best performing funds in the IMA Global Emerging Markets sector for the year to date to 30 May have been those focusing on smaller companies.

Of the top five funds in the sector three – the Somerset Emerging Markets Small Cap, the JPM Emerging Markets Small Cap and the Templeton Emerging Markets Smaller Companies – have a focus on the smaller end of the market.

The disparity in returns in the sector, also illustrates the difficulties of investing in such a diverse market with the Carmignac Portfolio Emerging Discovery delivering a positive 8.53 per cent compared to the Neptune Emerging Markets with a loss of 3.28 per cent in the same time period.

With the economic environment likely to remain volatile for some time to come, including presidential elections in Indonesia, Turkey and Brazil still to come this year, it has never been more important to understand the underlying investments in your funds.