Long ReadAug 9 2022

Why are emerging markets performing so poorly?

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Why are emerging markets performing so poorly?
(zhang-kaiyv/pexels)

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. 

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.

A better growth environment in emerging markets, led by a recovery in China, and fewer uncertainties around interest rates in the US will bring a supportive environment.Gustavo Medeiros, Ashmore

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."

Medeiros adds: "Interestingly, while the economy has been rapidly softening to recessionary levels in developed markets, it has improved towards positive levels in emerging markets as highlighted by the leading Purchasing Managers Index survey.

"A better growth environment in emerging markets, led by a recovery in China, and fewer uncertainties around interest rates in the US will bring a supportive environment for emerging markets.”

In the short term a strong dollar and weak US economy is generally seen as a negative for emerging markets.David Jane, Premier Miton

Chetan Sehgal, who runs the Templeton Emerging Markets Investment Trust, says that while the impact of the stronger dollar is well understood by investors, and is certainly contributing to present negativity, he feels it is less well understood that emerging market economies are in better shape to deal with the higher debt funding costs now than has been the case in the past, mainly because they have less borrowing.

David Jane, multi-asset investor at Premier Miton, says the problem is presently exacerbated by the present slowdown in the US economy, as there have been two consecutive quarters of negative GDP growth – the technical definition of a recession.

If US consumers and businesses are forced to reduce spending, then this reduces demand in the global economy, including for goods and services exported from emerging markets. 

Jane says: “In the long run you might think that resource rich emerging markets might do well. The world is short of energy, food and minerals given the lack of investment in recent years. However in the short term a strong dollar and weak US economy is generally seen as a negative for emerging markets.”

China conundrum 

Chinese equities comprise a very substantial part of the global emerging markets benchmark, and for many years the strong GDP growth rate of the Chinese economy also boosted the growth of neighbouring economies, and emerging market economies that are commodity exposures.

The Chinese government’s official GDP growth target for this year is 5.5 per cent, and with the economy re-opening the brakes China effectively applied to its own growth may be disappearing, and that recovery could boost the growth prospects of the wider emerging markets, according to Sehgal.  

But Kristina Hooper, global market strategist at Invesco, is cautious on the outlook for the Chinese economy.

She says: “The property market in China is increasingly problematic, and it is weighing on the country’s overall economy. Home prices are falling, many housing projects have stalled, and an increasing number of property owners are refusing to pay the mortgages on their properties currently under construction.

China might become uninvestable on political grounds.David Jane, Premier Miton

"However, China’s politburo did meet last week and pledged to support the property sector, including ensuring that unfinished building projects are completed."

Hooper adds: "In terms of the larger economy, the official July manufacturing PMI fell disappointingly to 49.0 from 50.2 in the prior month, though the good news is that non-manufacturing remains elevated at 53.8.7

"The weak manufacturing PMI indicates that the recent reopening-related economic recovery has started to falter, likely due to amplified property market woes and new pockets of Covid infections. Policymakers are likely to roll out further infrastructure stimulus to combat growth headwinds (as well as specifically supporting the property sector).”

Jane says that investors should strip China out of the wider emerging markets universe, and says it may be that the country is now “uninvestable.” He says that political and other factors mean the drivers of the Chinese stock market are not the same as the drivers of other emerging markets. 

He adds: “I would draw the distinction between China, which dominates the indices, and other markets such as India, south east Asia, LatAm and South Africa. These all have arguably very different drivers nowadays. We avoid China on the global decoupling and residential property disaster, particularly China might become uninvestable on political grounds” 

Inflation

Emerging market economies are particularly vulnerable to inflation, especially as their currencies tend to be weaker than the dollar, and most commodities in the world are priced in the US currency.

Therefore a stronger US currency is likely to have a disproportionately large impact on emerging economies, and is one of the reasons why food shortages have caused political strife in countries such as Sri Lanka, demonstrating that the impact of the stronger dollar can have long-term impacts. 

David Thorpe is special projects editor of FTAdviser