Emerging markets’ emergence
Emerging markets (EM) are emerging as 2023’s biggest star so far after a decade in the shadows.
Rock bottom arrived in October last year - not coincidentally about the time that Treasury yields and the dollar were peaking. Since hitting a nearly three-year low, the MSCI Emerging Markets index is up 12% (in euro). If we compare the EM benchmark with the MSCI Developed Markets (DM) index, its outperformance over the last three months now tops 8% (see the chart). Throughout its long hibernation, it has only once managed a rally this strong, in 2016 after fears of a Chinese financial crisis created a buying opportunity.
Dragging EM stocks down were a succession of risks faced by their economies, from the US trade war with China, to the onset of the pandemic and then Russia’s invasion of Ukraine and a pivot to a rate-hiking path by the Federal Reserve. China’s Covid lockdowns added to the pressure on the asset class. But China’s dismantling of Covid restrictions has led to a rebound in consumer confidence and benefited commodity exporters like South Africa with close ties to the world’s second-largest economy. Intra emerging market trade will improve if China improves. Inflation is also easing in nations from Brazil to India, while the potential that the Fed will slow its rate-hiking trajectory is bringing capital flows back into emerging markets.
Riskier assets like EM stocks have also regained favor as the dollar softened: A gauge of the greenback’s strength has slid almost 10% from a record high reached in October, ending a 21-month rally in the haven asset, and pushing EM assets higher. Historically, EM stocks tends to be inversely related to the dollar — a strong US currency generally means higher debt servicing costs and tighter financial conditions in the emerging world, and vice versa. With the dollar lingering near a six-month low, it is not so surprising that EM are strengthening.
But is it safe to assume that the dollar will keep weakening like this? Its fall over the last three months has been driven largely by falling Treasury yields, as some investors bet on a Fed “pivot” toward cutting rates. That makes the US a less attractive destination for capital flows. That bond rally continues, despite the Fed’s refusal to do anything to encourage the belief in an imminent pivot. If the bond market is right, it seems a fair bet that dollar weakness will continue — and it is notable that the 10-year Treasury yield remains barely above the 3.5% level it first reached in June, and far below its October peak of 4.33%.
The commodity market is another key driver of the greenback and EM stocks. As a rule, since commodity transactions are priced in dollars, they have an inverse relationship. Stronger commodity prices mean a weaker dollar, and vice versa (see the chart). Last year’s dollar rally took place as the main industrial commodities plummeted in the aftermath of the invasion of Ukraine. Now, industrial metals begin to look as though they are settling into a new upward trend and that tends to drive EM returns. The last big emerging bull market, in the first decade of this century, came as a China’s growth prompted massive demand for industrial materials, generally from other countries in the emerging world. It is true that the commodity spike of 2021, which helped to ignite inflation in developed markets, didn’t much help EM stocks; that was at least in part because many developing world central banks were obliged to start hiking rates then. If industrial metals are going on another rally, that should be good news for EM stocks.
Finally, cheaper valuations and better earnings prospects are luring investors back to emerging markets. The MSCI EM index traded at a discount of almost 40% to the MSCI DM index at the beginning of last year, based on forward-looking price-earnings (P/E) ratios. The rally since then has reduced that discount, taking it to 30% (see the chart). That is the narrowest gap since March 2021 but still below the long-term average (25%).
However, it cannot be excluded that the road to Chinese reopening will be bumpy - China is currently in the grip of a severe Covid wave. So will the performances of EM equities and currencies. But if the key assumptions hold true that the Fed starts relenting on tighter rates, and that China soon resumes its economic strength in full vigor, then it should be a fair bet that emerging markets will fare nicely indeed, both in absolute terms and relative to the US and the developed world. Both of those assumptions will inevitably be tested in the months to come. For longer-term investors, buying or overweighting EM now looks a good idea. For shorter-term investors, the chances are that they will be tested by volatility along the way.