Global Emerging Markets Q2 2016 Update
The first quarter of the year saw emerging market equities gain 5.8% in US dollar terms as global economic conditions created a more favourable backdrop for the asset class, with the US dollar peaking and the crude oil price bottoming in January. We also saw emerging market currencies appreciate against the US dollar for the first time since October, gaining about 5% since late January, with double digit returns in March alone for Russia’s ruble and Brazil’s real, aided by the US Federal Reserve’s commitment to low interest rates in order to support global growth and stability. Emerging markets equities showed their sensitivity to changes in macroeconomic indicators, gaining 13.2% in March alone, a level last matched in October 2011. Notably, small cap stocks have lagged large cap stocks as the universe has less exposure to the energy sector. It’s probably too early to predict if this current environment represents a rally in a bear market or an inflection point to a more sustainable long term recovery for emerging markets.
Since 2011, emerging markets have tended to underperform developed markets. This has been the case in particular since mid-2014, when commodity prices began to fall even faster. It was also at a time that individual economies also started to face their own, specific problems, such as in Brazil. But so far this year, emerging markets have managed to weather the turbulence caused by volatile oil prices and concerns over China. In recent years, emerging markets have accustomed us to short-lived spikes.
Since the normalisation of US monetary policy was announced in spring 2013, emerging economies have been constantly exposed to new shocks. Economically, the drop in commodity prices that began in mid-2014, which came at the same time as the Chinese slowdown, may have benefited all end-consumers but hit net commodity exporters hard, through depreciation in their currencies, higher inflation, tightening of the policy mix, etc. In the wake of additional geopolitical idiosyncratic shocks, Russia and Brazil look like the big losers among emerging economies with both suffering recessions of close to 4% in 2015, recessions that are unlikely to end until late 2017. Not all emerging countries have been affected the same by falling commodity prices and the Chinese slowdown. Commodity-exporting economies that had adopted hawkish monetary and fiscal policies such as Mexico, Chili, Peru and Colombia, had room to mitigate the impact of tighter financial conditions caused by the depreciation of their currencies, unlike Venezuela and Brazil, for example.
For net commodity-importing countries, particularly Asian ones, lower commodity prices have helped offset the impact of the Chinese slowdown to such an extent that most of these countries’ growth in 2015 was about the same as in 2014. Central Europe, meanwhile, benefited from both lower commodity prices and a strong German economy. All in all, GDP growth in emerging markets shrank by about one percentage point from 4.8% in 2014 to 4% in 2015. While all regions were hit by slower growth, there were still some wide divergences. For example, while emerging Europe and Latin America turned in slightly negative growth rates, Asia expanded at almost 6%. However, there were also wide differences between countries within the same region. Countries do not differ on the basis of growth criteria alone. Central bank monetary policies have also been tightly restrained by the international economic environment. Whereas net commodity-exporting countries have had to raise their key rates to varying degrees, in reaction to pressures on their exchange rates and domestic inflation, Asian and Emerging Europe countries have begun monetary easing cycles due to de/disinflationary pressures from the euro zone, as well as China.
The resilience of major economies should provide some support for emerging economies. First of all, in advanced economies, the euro zone and the United States in particular, economic indicators are relatively reassuring, even if they still point to soft growth. In the US, job market figures in particular calmed the markets, and a recession appears to be less likely. Moreover, US rates are likely to be tightened less than had been expected a few weeks ago. The median Fed Fund projections of FOMC members is now just two Fed funds hikes in 2016, down from four at the December FOMC meeting. Emerging economies, whose financing conditions have worsened considerably since 2014, are expected to be less constrained in terms of monetary policy, which will provide a boost for these countries.
In the Eurozone, in addition to economic indicators, the ECB’s announcements made on the 10th of March were well above the markets’ expectations, in contrast with after the Council of Governors’ meeting last December, and that should make it possible to stabilise growth in the euro zone. Moreover, measures announced by the Chinese authorities reinforce the premise that China is likely to avoid a hard landing. And, regarding oil, February discussions between producing countries, while not resulting in any concrete agreement, at least prevented a further drop in prices.
All these factors have helped lower risk perception and make risky assets more attractive, including emerging assets. However, while global uncertainty has receded and risk perception has declined, it’s probably wise to remain cautious. In Europe and the euro zone geopolitical risks, terrorism, political instability in peripheral countries, the migrant crisis, and a possible Brexit, could undermine growth if they were to last or gather in strength. In the United States, while a recession is quite unlikely, manufacturing figures point to downside risks. In China, the authorities are clearly trying to switch growth models without major disruption, but any transition process is inherently uncertain and the risk of an incident can never be ruled out. Meanwhile, commodity-exporting countries and some Asian countries closely integrated with China have not begun or completed their own process of adjusting to more diversified production models. With commodity prices likely to remain low for a long time to come and with demand relatively sluggish, it will be even more difficult for these countries to carry out the reforms they need, in order to stabilise growth in the medium term.
Emerging markets have held up well at the start of this year. The stabilisation of oil prices and topping off of the dollar have proven to be powerful catalysts, especially as these markets appeared to be oversold and inexpensive. However, economic fundamentals remain shaky and caution is still in order. The rebalancing of the Chinese economy towards more consumption is a slow process and corporate deleveraging has only just begun. That said, cyclical recoveries always begin with tactical rallies, during which it is better not to be underweight. For this tactical rally to turn into a cyclical rally several conditions probably need to happen. China’s economy will have to continue to stabilise, given its impact and influence over other emerging economies. Oil and industrial commodities will have to continue to rally, the renminbi will have to remain stable and the US dollar mustn’t rise too much. If these conditions are met, emerging markets could well provide a positive surprise this year.