Emerging Market Cycles and Diversification

Day to day market movements often seem to suggest that emerging markets are highly correlated with developed markets, and in 2008 or 2011 emerging equity markets were not generally a useful place to hide.

By Hamlin Lovell

One perception is that globalisation, trade and economic convergence make the world more interconnected, and reduce the diversification benefits of crossing borders. Some observers have even argued that the emerging markets no longer deserve their name. But EM investment returns over multi-month, or multi-year, periods, can diverge from DM.

Equities
Between 2013 and 2014, developed equity markets were in a bull market, while emerging equity markets lost a small amount of value, as measured by MSCI indices. Mainland China stocks then had a 30% crash in 2015, helping to drag the EM index down by more than 15% in that year, while developed indices were close to flat.
Emerging markets found a trough in early 2016 – and anyone lucky or smart enough to have bought the lows might have doubled their money, two years later by early 2018. Over this recovery period, EM equities have generated roughly triple the returns of DM equities.

Economic growth
EM have been growing their economies faster than DM for many years, but many observers focus on the EM/DM growth differential. This narrowed between 2009 and 2014, then stabilised, and has been expanding since 2016. Both DM and EM growth have been accelerating in 2017, but EM has been increasing its lead. This has contributed to EM equity outperformance.

Commodities
Commodities are part of the story. The oil price also reached a six-year nadir in early 2016, and wider baskets of 20 or more commodities touched the lowest points since 1999. This is particularly relevant to commodity-producing countries such as Russia, Brazil and South Africa; though some other emerging markets are net importers of commodities, in aggregate EM are net exporters.
However, large and usually state controlled oil producers are no longer the largest parts of the EM equity indices. They have been replaced by the BAT complex (Baidu, Alibaba, Tencent); by firms such as Naspers where the valuation is largely derived from the Tencent stake, and by longer established tech firms like Samsung.

Though the surge in technology stocks is seen in both EM and DM, economic cycles are also different in emerging markets. Brazil has just clawed its way out of its worst ever recession, which saw the economy shrink by some 7% over 2015 and 2016. At that time, developed economies were growing steadily.

Interest rates
Little wonder, then, that Brazil has been through five interest rate cycles over the past nine years, when most developed economies held rates steadily around zero. In fact, all four of the BRICs have interest rate policies that are rather independent of developed markets. India also has a rather idiosyncratic interest rate cycle. Its central bank raised interest rates from 4% to 8.5% between 2010 and 2012, and has since 2015 cut rates down to 6%. Russia, as well, does its own thing on monetary policy. Rates trebled from 5% to 15% in the first half of 2014, and have since then halved down to 7.5%. China’s interest rates have also come down from 6% to 4.5% since 2015. All of this generates more volatility in government bond markets, and more opportunities for diversifying rather duller developed bond markets.

Currencies 
Currencies are another part of the jigsaw. EM currencies bottomed out in early 2016, at around the same time as EM equities. To the extent that both asset classes can be driven by asset flows, it is natural for EM equities and currencies to rise in tandem.

Currencies also influence interest rate policies. Weaker currencies increase the cost of imports, which can contribute to inflation and interest rate hikes. Stronger EM currencies in contrast can help to reduce import costs, slow down inflation, and leave central banks more leeway to cut rates – or at least refrain from raising them. Stronger EM currencies also make it easier for governments and corporates to service and repay hard currency debt.

Politics
In developed markets, central banks, such as the Federal Reserve, ECB or Bank of Japan, are officially independent (even if there are doubts in some countries, such as Hungary). In many emerging markets, central banks are explicitly under political control. This means that a change of government or ruler can have far reaching impacts on monetary policy, rather like Sweden in the 1990s. The People’s Bank of China (PBOC) serves the Communist Party, and is said to require approval for the various interest rates it sets. Brazil’s central bank is not fully independent (though there are discussions about giving it more power). The Reserve Bank of India is officially independent, but an academic paper by Nergiz Dincer and Barry Eichengreen, published in the International Journal of Central Banking, found it was the least independent of 89 central banks they analysed, based on various criteria. Potential for political interference in monetary policy is another source of alpha for managers who are confident about predicting the paths of politics.

Frontier markets
Still, for some adventurous investors, emerging markets do not offer enough diversification. There is in fact something of a grey area in drawing a line between emerging and frontier market, and it can vary by asset class. Countries, such as Argentina, that are regularly described as being “emerging markets” – at least when it comes to sovereign bonds – are in fact constituents of some “frontier market” indices – as far as equities are concerned. Argentina is the largest weighting in the MSCI Frontier Markets index. In some cases, the attraction of frontier markets is a secular growth story so strong – in an economy so small – that it might be almost immune from global economic cycles. Countries such as Vietnam, Cambodia and Myanmar, are at a stage of economic development where simply migrating millions of workers from the agrarian to the urban economy can lead to leaps and bounds in productivity and growth.

Yet in frontier markets there is less liquidity with some observers suggesting that publicly quoted equities are more akin to private equity. In these conditions, closed end funds that are insulated from the pressures of selling to meet redemption requests, may be preferable to open ended vehicles.