Emerging market equities have performed poorly since the beginning of the year. More recently, trade tensions between the US and China, a rising US dollar and issues in individual emerging market economies have hit emerging markets.
The last emerging market downturn was in 2015 on the back of Chinese growth concerns, a devaluation in the Chinese Yuan and Fed interest rate hike fears. Emerging market economic fundamentals (GDP growth, national savings, current account balances and government budgets) are now in better shape compared to 2015.
US dollar denominated external debt makes up a decent chunk of total debt outstanding for emerging markets (averaging around 30%) but is manageable in the current environment of better economic fundamentals. The US dollar appreciation also appears to be close to a peak.
Emerging market equities and currencies may face more downside in the current risk off environment. But, global growth is still good, economic fundamentals are holding up and some policy easing from China is likely which will help emerging markets. So, a broad-based emerging market downturn is unlikely to occur.
Global share markets have taken a tumble over recent weeks, as concerns around a US-China led trade war have dominated headlines. Emerging market (EM) shares have been hit particularly hard, although this weakness in EM equities really started in March (the MSCI EM index is down by nearly 10% since the peak at the start of the year in local currency terms and by 18% in US dollar terms). The concern around EM economies has come off the back of global trade tensions but also from:
- The lift in the US dollar (USD), up by 7% since its bottom around February, which has occurred as the Fed has been lifting interest rates and global growth has become less synchronised and more US-led (which tends to result in a higher USD). A rising USD is seen as a negative for emerging market economies, because foreign debt in these countries is predominately issued and denominated in USD.
- Specific problems in individual emerging market economies, most recently in Argentina and Turkey due to deteriorating current account positions and capital outflows which lead to a weaker currency, lifting inflation and driving sudden interest rate hikes from the central bank. Weakness in external financing is negative for confidence, which loops back into outflows and exacerbates this cycle. Election risks in EM economies (Mexico and Brazil) have also been keeping investors cautious.
EM economic growth, share markets and currencies tends to be volatile and there have been numerous examples in recent history of worries around EM markets leading to broader share market falls (e.g. 1997/98 Asian/EM crisis and the 2015-16 China-led EM downturn). The key question for investors is: are we at that point where the downturn in EMs turns into a major bear market and drags developed market equities with it, along with global growth? In this Econosights, we look at how emerging markets are currently positioned compared to history and whether there are any red flags investors should watch for as sign of a growth deterioration across these economies.
A backdrop to emerging markets
After the Asian/EM crisis (in 1997-98), EM economies implemented various reforms to lift productivity, decrease reliance on foreign capital and float exchange rates which boosted growth in the 2000s. The industrialisation of China at the time and the subsequent surge in commodity prices provided a big boost to underlying EM performance.
Post-GFC, poor growth in advanced economies encouraged capital to flow to the stronger EMs, supporting growth in these countries. But, since 2011, EMs have come out of favour and have been underperforming developed market shares (see chart below). In 2015, EM equities faced a difficult period because of heightened concern around weakening Chinese growth (especially after the authorities devalued the currency), a recession in Brazil and Russia after the collapse in oil prices and uncertainty around interest rate hikes from the Fed and its impact on the USD.
Since 2016, the cyclical global growth upswing has predominately been based in developed markets (US, Eurozone and Japan) after years of easy monetary conditions and easy liquidity which has lifted asset prices in these markets. The chart below shows the turnaround in manufacturing business conditions across developed economies, while EMs have lagged behind. EMs have still benefited from the strength in the global economy and more recently, through the reliance on global trade.
But, EMs are still more important to global growth now than compared to history. EMs make up close to 60% of world GDP (based on purchasing power parity) with a large majority of this due to China, while developed markets are now around 40% of world GDP.
Emerging market economic fundamentals
We outline important indicators to watch for key EMs in the table below. We compare current conditions to 2015 (the last time EMs faced a downturn). Overall, we find that underlying EM fundamentals over the past three years have improved. GDP growth is holding up well, (which is important to ensure that debt servicing does not deteriorate) with Brazil and Russia now out of recession, current account positions have generally improved, national savings have been maintained and government budgets are under control. These indicators are important to keep monitoring, as a sign of any potential deterioration in EMs.
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