Reflecting on August
What has happened?
After outperforming during 2017, emerging market (EM) equities have underperformed their developed market (DM) peers this year. While the MSCI World, a developed market index, has risen by 3.4% since the turn of the year, the MSCI Emerging Markets Index has declined by 8.9% and the MSCI Frontier Emerging Markets Index has fallen by 11.4%. This trend of underperformance continued in August, with the MSCI Emerging Market Index falling by 2.9%, in contrast to the 1% gain for the MSCI World. The MSCI Frontier Emerging Markets Index fell 3.3% over the same period. Amongst the weakest performing markets during the month were those in Argentina and Turkey. In US dollar terms, the Argentinian Merval Index declined 27.2% and the Turkish BIST 100 Index 28.8% in August, as the Argentinian peso and Turkish lira came under tremendous selling pressure. The weakness wasn’t just confined to the equity markets, with the government bonds of both Turkey and Argentina falling in value.
There are a number of reasons for the underperformance of emerging markets this year. Having ridden the wave of improving economic growth in 2017, emerging markets have suffered as GDP growth expectations in a number of regions have moderated slightly this year. According to Bloomberg, emerging economies grew on aggregate by 5.0% in 2017 and consensus estimates are for this rate of growth to slow to 4.8% this year. Developed economies, meanwhile, are forecast to match last year’s 2.4% growth this year, before GDP moderates in 2019 and 2020 at 2.1% and 1.8% respectively.
Emerging markets have also been impacted by the US Federal Reserve’s tightening of monetary policy. The Fed has raised rates three times since the beginning of December 2017, and is expected to do so again later this month. This policy tightening has contributed towards strength in the US dollar and combined with higher rates makes dollar-denominated debt issued by EM countries more expensive to service.
Political risks have also contributed to the weakness. The Shanghai Composite Index has lost 17.6% of its value since the beginning of the year as US President Trump has hit Chinese goods with tariffs and threatened to take further action to prevent what he sees as “unfair transfers of American technology and intellectual property to China”.
Finally, oil importing emerging economies have been hit by a more than 15% rise in the price of crude year to date.
What should you take away from it?
Emerging markets are by their very nature more volatile than developed markets. However, they also provide access to economies with faster growth rates at valuations that are, by a number of metrics, cheaper than their developed market peers. For example, the MSCI Emerging Market Index, on a forward price/earnings basis, currently trades on a 25% discount to the MSCI World Index, wider than the c. 20% average of the last ten years, and despite the still healthy growth expected from the region.
Furthermore, it is important to note that not all emerging and frontier markets are the same. The asset price declines in Turkey and Argentina have come about in part due to the issues outlined above that have impacted all emerging economies. However, these economies face some very specific difficulties. Turkey and Argentina run significant current account deficits, a common characteristic amongst emerging economies that come under financial distress. Both are also faced with rampant inflation, something which the Turkish central bank has been slow to respond to due in part to pressure from the country’s President, while, both also have high levels of foreign currency debt. In contrast, economies in relatively strong financial positions, including those with current account surpluses such as Taiwan and Thailand, have seen their stock markets perform relatively well.
While not appropriate for everyone, we continue to believe that for investors able to take a long-term view, and withstand bouts of heightened volatility, emerging markets can form an attractive part of a broader portfolio, particularly given their valuation relative to developed market peers. As ever diversification is of the utmost importance, with a sensible way to gain exposure being through a number of well-managed funds that operate in the space. Please speak to your Investment Manager for any further information.
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