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Ewan Thompson
Ewan Thompson 20-07-22

Why emerging markets are proving resilient

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

The first half of 2022 has undoubtedly been one of the most challenging periods in global markets since the Global Financial Crisis (GFC) over a decade ago. Yet emerging markets have proven relatively resilient in a volatile environment in which they would be expected to struggle more than developed markets.

 

The emphatic market and economic recovery from the nadir of Covid lockdowns in 2020 has seen global supply chains strain to breaking point, leading to accelerating inflation underpinned by elevated commodity prices and scarcity of supply of vital electronic components.

 

In response to rising inflation expectations, global monetary policy expectations have shifted decisively, with the US Federal Reserve embarking on a tightening cycle in March. More importantly, the market has dramatically revised upwards both the terminal rate and speed of getting there. The 0.75% increase at the June meeting alone underscores how sharply the Fed’s response function has shifted. Of course, such a rapid increase in expectations of monetary policy tightening has come with concerns over growth and widespread predictions of a US recession. Equity markets have clearly been roiled by this torrid backdrop, with the worst first half of the year for equities in 50 years.

 

If these global crosscurrents were not enough, emerging markets have also been buffeted by their own specific set of issues. Most visible has been the fallout from Russia’s military incursion into Ukraine, which has resulted in significant impacts to the supply (and therefore price) of key commodities and has seen the Russian equity market removed from the MSCI Emerging Markets Index. This combination of severe global macro headwinds and emerging market-specific burdens represents one of the most challenging backdrops for emerging markets’ relative performance in decades.

 

And yet it is remarkable that at the halfway point of the year, emerging markets have outperformed their developed market counterparts − a highly unusual outcome in downward trending, volatile markets. Indeed, as markets sold off even more aggressively in the second quarter, emerging markets’ outperformance increased, with MSCI Emerging Markets falling 12.3% against MSCI World’s drop of 16.6%. Whilst this is still a painful absolute return, it should be reiterated how unusual it is for emerging markets to prove more defensive than developed markets in such periods of market turmoil.

 

Moreover, MSCI China eked out a positive return in the second quarter − and remains the only major market that has not undercut the lows of the March sell-off (for comparison, the S&P 500 index currently sits about 10% below the March lows). The relative strength of the Chinese market is most starkly revealed when comparing the performance of Alibaba (China’s e-commerce giant) with that of Amazon - the former has posted a positive return and has outperformed the latter by 40% in the second quarter.

 

What explains the (comparative) resilience of emerging markets? Given the sharp increase in volatility and severe negative market returns, ordinarily, emerging markets would be expected to fare considerably worse − especially in an environment in which the dollar has been extremely strong alongside sharply higher interest rates. The answer comes in several parts but what is most instructive is the relative starting points for emerging and developed markets going into the start of this year.

 

Developed markets have ridden high for a decade on cheap money and negative real interest rates, with valuations reaching extreme levels. Meanwhile, the MSCI Emerging Markets Index sits at similar levels to where it was in 2007. Quantitative easing has famously been hard on emerging markets, with their equity markets largely having been bypassed by the bull market experienced in the developed world. But emerging markets have generally used this time productively, executing prudent policies and repairing their economies.

 

The taper tantrum of 2013 triggered shock waves across unprepared emerging markets and coined the term ‘Fragile Five’ (Turkey, Brazil, India, South Africa and Indonesia) for those markets that found themselves on the wrong side of rapidly increasing interest rates. The dramatic increase in market rates we have seen in the past 18 months dwarfs those seen in that period, yet the vast majority of emerging markets have weathered this storm capably. A key factor in this preparedness has been emerging markets central banks’ willingness to get ahead of the curve and hike interest rates aggressively well before the US Federal Reserve started to move.

 

Therefore, while developed markets suffer the shock of moving from negative real (and even nominal) rates to sharply positive, many emerging markets are already close to the end of their tightening cycles and now have plenty of room to cut rates when inflationary pressures ease.

 

With market concerns over a potential US recession growing, the market is now looking to the second major engine of global growth − China − to provide some of the heavy lifting. In this regard, the easing of Covid restrictions in recent months, alongside a notable positive shift in rhetoric towards the technology and e-commerce platforms, is extremely welcome, with China once again operating somewhat counter-cyclically to the rest of the world. It is true that the zero-Covid policy remains in place and the green shoots of opening up could well be hindered by a renewed surge in cases, but there are also promising signs of a domestically produced (and therefore politically acceptable) mRNA vaccine that could offer the exit strategy to the current policies that the economy desperately needs. A stabilising China is an extremely powerful positive force for emerging markets due to its significant weight in the asset class and its ability to boost regional growth.

 

Whilst China’s relative recovery has been the notable story of the second quarter, we should not forget the ongoing robust performance of that other emerging market powerhouse - India. Since the global market recovery began in April 2020, India has consistently outperformed both developed and emerging markets, driven by a combination of market-supportive policy and domestic cyclical recovery.

 

One of the Fragile Five a decade ago, India has now demonstrated impressive resilience in the face of sequential macro shocks. Once considered one of the countries most vulnerable to higher oil prices, India has outperformed developed markets in a year when oil prices have hit nearly $140 per barrel and averaged over $100. India’s oil intensity per unit of growth has declined steadily in the past decade and successive policy reforms have effectively removed the subsidy regime that proved so costly to the government in previous periods of high prices.

 

The stringent fiscal policies under the Modi administration have created a solid fiscal framework that is now paying dividends. The cyclical improvement in the economy remains strong, tax receipts are accelerating and the housing market continues its recovery from the doldrums with the potential to spark a wider private capex cycle. The March state elections − successful for the incumbent BJP − underscored the reality of unprecedented political stability and ensured that policy stability continues.

 

The mood is positive across the corporate spectrum and although inflation is an issue − as it is everywhere − it is an incremental move upwards in an economy used to running at 5-6% inflation rather than the dramatic shifts we have witnessed in the UK and US. Moreover, the one criticism levelled at the Indian market at the end of 2021 after a spectacular year of performance was that valuations were too extended. Yet as markets have corrected, the market P/E is now back to average levels.

 

While 2022 has presented an extremely challenging backdrop for emerging markets, one that on paper would have been expected to have seen significant underperformance for the asset class, the impressive resilience seen in key emerging markets in these conditions has been notable. The two key emerging markets − China and India − continue to be driven by idiosyncratic factors. We believe that once global growth expectations settle, a key headwind for emerging markets will have been removed while valuations remain at attractive levels relative to developed markets.

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KEY RISKS

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Investment in funds managed by the Global Equity (GE) team may involve investment in smaller companies - these stocks may be less liquid and the price swings greater than those in, for example, larger companies. Investment in funds managed by the GE team may involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The team may invest in emerging markets/soft currencies or in financial derivative instruments, both of which may have the effect of increasing volatility. Some of the funds managed by the GE team hold a concentrated portfolio of stocks, meaning that if the price of one of these stocks should move significantly, this may have a notable effect on the value of that portfolio.

DISCLAIMER

This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID), which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.co.uk or direct from Liontrust. Always research your own investments. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.

This should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust.

Ewan Thompson
Ewan Thompson
Ewan joined Liontrust in October 2019 as part of the acquisition of Neptune Investment Management, where he started his investment career. Prior to joining Neptune in 2006, he worked as an editor for Yale University Press. 

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