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Why are emerging markets performing so poorly?

Why are emerging markets performing so poorly?

The most startling fact about emerging market investing is that, over the past three years, the average global emerging markets fund has lost 0.4 per cent.

During the same time period, the average fund in the IA Global Equity sector is up around 24 per cent. 

Data compiled by our sister publication, Asset Allocator, shows that only two from 123 global emerging markets funds delivered a positive return in the first six months of 2022. 

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The three-year period includes the start of the Covid pandemic, which initially plunged all stocks into free fall, but while global equities have generally recovered from the impact of Covid on asset prices, the recovery has yet to be felt by emerging market investors. 

Part of the reason for this has been the very different experience that many emerging markets have had on exiting the pandemic, with China pursuing a zero-Covid policy, impacting aggregate demand in that country and its neighbours.

Higher interest rates

But the exit from the pandemic has also led to significantly higher than target inflation, with the response to this being higher interest rates from the US Federal Reserve.

This is bad news for most emerging market economies and companies because they usually have to borrow in dollars to fund themselves.

Because those companies and countries generate the revenue they use to pay off debt predominantly in their own currency, a rise in the value of the dollar means they have to use a greater amount of their own currency to repay the dollar debt.

In the case of a private company, this leaves less revenue to distribute to shareholders; in the case of a country, it uses up more of the state revenues on debt repayments, leaving less for social projects or future growth.

Higher US interest rates would typically be expected to cause the dollar to rise, as it has done in recent months.

Gustavo Medeiros, head of research at specialist emerging markets fund house Ashmore, acknowledges that dollar strength is negative for emerging markets, but says: “A simple formula to anticipate emerging market assets’ performance is growth divided by cost of funding.

"China is the engine of global growth, and the US issues the reserve currency of the world, so when Chinese growth slows down and US rates increase, as we have witnessed since 2H 2021, emerging market asset prices are challenged.

"The Chinese politburo just acknowledged the growth challenges and is putting serious measures in place to backstop the hard landing of its key real estate market, while [Fed chair Jerome] Powell just acknowledged the end of the hiking cycle may be near in the US as companies are faced with high inventory levels after demand slowed due to low real wage growth."