Emerging from the depths

 

Emerging markets are becoming more prominent in the world economy. Victoria Harris explains what’s driving this region’s stellar performance and evaluates the prospects for sustained growth.

In less than 30 years, Emerging Markets (EM) have grown from just 10 countries that represented less than 1 per cent of global market capitalisation, to a dominant investment region that makes up nearly 15 per cent of the world’s equity markets. 

Over that time, EM economic and financial stability have improved dramatically. Corporate profitability has also reached levels more usually seen in the developed world.  

And in 2017, EM share markets performed particularly strongly. According to investment research firm MSCI, its Emerging Markets Index delivered a return of nearly 40 per cent (in US dollar terms) and significantly outperformed the MSCI World Index. This performance was driven mainly by the major markets of China, India, and South Korea. 

Of 24 emerging countries, only the United Arab Emirates and Qatar experienced negative returns in the period. Both regions had sluggish economic growth and faced geopolitical uncertainties that affected investor sentiment.

What drives Emerging Market performance? 

To generate investment gains in this asset class, you need to understand the three key driving forces behind EM economics and, in turn, EM equity markets:

1. The US dollar

The US dollar is always going to be dominant in EM equities, simply because EM share prices are measured in US dollars. 
In the past three decades, when the US dollar has trended weaker, the relative performance of equities in Emerging Markets compared to Developed Markets has been stronger, and vice versa.

2. Capital flows

If demand exceeds supply, prices increase. This basic economics theory applies to EM prices. As the level of investment into EM equities increases, so too does the relative performances of their share prices. 

Price actions and capital flows reinforce one another. And for EM equities, this can lead to extreme peaks and troughs in share prices as the markets temporarily overreact and they adjust to changing levels of investment. This explains the volatility of EM equity markets.

3. The Chinese economy

EM equities are highly cyclical, as is China’s economy. The relationship between China’s business cycle and EM share prices was established two decades ago – before Chinese equities were even considered investable on global financial markets. 

China represents 30 per cent of EM indexes, so EM cycles show similar patterns to the Chinese economy. This means if you’re investing in EM, you need to pay close attention to what’s happening to the Chinese markets.

What’s the outlook for growth in 2018?

EM countries and equities are under-represented globally. The EM economies now make up 40 per cent of the world economy (in US dollar terms) but account for about 60 per cent of global economic growth. 

EM growth is likely to continue to outpace Developing Markets growth, because lower average-income levels make it easier to grow at a faster rate. Although the share markets care about profit growth, not gross domestic product (GDP), profits are ultimately linked to economic growth in the long run.

And with emerging countries accounting for just 15 per cent of total global market capitalisation, the potential for share prices to rise creates good opportunities for investors.

In a world where relatively few financial assets can be considered ‘cheap’, EM equities seem to offer good value compared with both their historical average and Developed Markets. Economic tailwinds are likely to continue to lead to both faster earnings growth and a bigger potential for expansion than assets in the developed world.

What could go wrong?

World trade has made a strong recovery over the past 18 months. But global protectionism policies and a possible US-China trade war are still a concern.

The direct impact of these factors on global growth in the next year or two would be low, as US-China trade is small relative to the size of the world economy. However, the impact on Emerging Markets, due to their exposure to China, is far greater. 

In a best-case scenario, US protectionism will be limited and will stop short of a global trade war, and all parties will negotiate better terms of trade that work for all involved. 

However, the unpredictability of US trade policy and other countries’ responses still poses a key risk.  

Who are the star performers?

One region to watch is Emerging Asia and, in particular, India. For decades, Emerging Asia has benefited from favourable demographics. Most of the region is still young, which should continue to boost economic growth. 

In India, stronger individual and government spending should lead to higher GDP growth in the short-to-medium term. 

Longer term, Indian Prime Minister Narendra Modi’s reform agenda has delivered some successes, which should help to boost India’s productivity. This would make the region more competitive on a global stage. And the indications are strong that India will outperform the rest of the emerging world over the next decade.

Definitions: 

Emerging Markets: An emerging market (EM) country has an economy that’s becoming more advanced, with liquidity in local debt and share markets, some form of market exchange, and regulation. 

MSCI includes 24 countries in its EM index: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. 

Gross Domestic Product (GDP): GDP is a measure of a country’s market value. It covers all goods and services produced within a time frame, and can be used to compare nations’ economies.

Protectionism: Protectionism is where a government’s policies aim to restrict foreign imports, to protect that country from international competition.

First published Autumn 2018

Story by Victoria Harris, Pie Funds

The editorial above reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.


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