Global equity markets, as measured by the MSCI World index, have not seen a bear market (i.e. a market correction of 20% or more) since 2011, solidifying and reinforcing the ‘buy the dip’ mantra of recent years that could be heard with every instance of market weakness. 2018 is looking to be no different, with global markets having already recovered more than half of their losses from the steep sell-off in January/February.
Exhibit 1: Graph showing performance of MSCI World Index and MSCI EM index, indexed to 100 from 2008
Source: Bloomberg, BNP Paribas Asset Management, as at 03/10/2018
However, emerging market (EM) equities remain the exception: they – briefly – entered bear market territory in early September. The question now is whether EM equities will resume their prolonged underperformance, which began in 2011 with the Arab Spring, or whether the asset class can rebound and continue its rapid appreciation following the China slowdown of 2015.
RATs – like PIIGS, but uninsulated by a common currency
To begin to answer this question, we must first determine what the principal influences have been in the latest downturn. One likely explanation is the ‘RATs’ (Russia, Argentina and Turkey) of EM resembling the ‘PIIGS’ (Portugal, Italy, Ireland, Greece and Spain) during the European crisis, or worse. Unlike the PIIGS, the RATs are not insulated by a common currency.
The pain of this reality has been felt most acutely in Turkey and Argentina, whose currencies are down by 42% and 50%, respectively, year-to-date, at the time of writing, as investor flows have rapidly retreated. However, in Argentina, the International Monetary Fund has increased its credit line to the country to USD 70 billion and the central bank has aggressively raised short-term rates to 60% to defend the currency.
Exhibit 2: Performance of EM currencies relative to the US dollar 2018 YTD
Source: Bloomberg, BNP Paribas Asset Management, as at 28/09/2018
By contrast, in Turkey, President Recep Erdogan has stated that “interest rates are the mother and father of all evil” and his consolidation of power has rendered the independence of the central bank questionable, at best. Despite Erdogan’s disdain for interest rates, rampant inflation has inevitably forced the central bank to sharply raise the policy rate to 24%. Whether or not this is the necessary first step to rein in inflation or support the flagging currency, it should be noted that the country accounts for only 0.5% of the MSCI EM index and has minimal financial linkages to the global economy.
Exhibit 3: Breakdown of MSCI EM index by country
Source: MSCI, BNP Paribas Asset Management, as at 28/09/2018
In Russia, sanctions could pose the greater risk
The situation in Russia is much different, but still one of concern. The economy has held up rather well relative to that of Turkey and Argentina due to the recent strength in the price of oil. The Central Bank of Russia only had to raise policy rates by 25bp in September, which was a conservative decision given that it maintains one of the highest real interest rates in the world, even after considerable policy easing over the last few years.
We believe the larger risk facing Russia is a seemingly endless wave of sanctions imposed by the West. Investors worry about proposed bans on trading new Russian government debt and limits on the operations of state banks, which make up roughly two-thirds of the financial sector. Concurrently, foreign direct investment fell by more than 50% in the first half of 2018.
The broad weakness in EM this year is likely not explained by the mostly isolated risks posed by these countries, though. More plausibly, economic weakness in China from escalating trade tensions against a backdrop of already slowing growth has had a larger impact. Most recently, the US imposed 10% tariffs on USD 200 billion of Chinese goods, which are set to rise to 25% at the start of 2019, and China has since retaliated. Even worse, neither side has given any indication of backing down from the stand-off.
EM investor jitters from China weakness and USD strength
In the US, there is yet to be any impact on the economy or financial markets, although there likely will be one if there is no agreement. Meanwhile, in China, yuan depreciation has offset much of the impact so far. President Xi Jinping might also delay decisive action until after the US mid-term elections. In US dollar terms, the MSCI China index was down by more than 25% in mid-September from its peak in January, and the onshore equity market fell even further. As the second largest economy in the world, China is easily the largest component of the MSCI EM index, so it is logical to assume that China has been a significant driver of EM underperformance this year.
Exhibit 4: Performance of MSCI China index since 01/01/15
Source: Datastream, BNP Paribas Asset Management, as at 03/10/2018
Lastly, the impact of a strong US dollar has likely also added to investor jitters over EM. With the US continuing its rate-rising cycle, a relatively stronger US economy and shrinking US dollar liquidity, the dollar has appreciated sharply and net speculative long positions in it have reached their highest point in more than a year, approaching levels not seen since the immediate reaction to the Trump election. However, the recent relative growth outperformance is partially due to the temporary jolt from US tax cuts and one would expect the widening budget deficit, especially during a peaking business cycle, to limit the potential upside for dollar appreciation.
EM risk/reward potential looks increasingly attractive
There are a number of risks facing EM equities this year that were notably absent in 2017, but EM countries are generally better equipped to tackle these challenges than they were a few years ago. Current account deficits have improved considerably since the taper tantrum of 2013. EM equity valuations are now at a considerable discount to those of developed markets and well below their long-term average.
This is despite the evolving EM index composition, which now includes considerably more exposure to the growth-oriented consumer and information technology sectors at the expense of the more value-oriented energy and raw material sectors than it has had historically; that alone justifies a higher valuation than the long-term average. Forecasting short-term market moves is not our expertise, but we can say with confidence that the risk/reward potential for the asset class looks increasingly attractive.
Recent EM weakness presents an opportunity
In the long term, we believe the asset class still offers favourable growth dynamics and is under-represented in global indices in terms of market capitalisation in proportion to the global population and global economic output. The opportunity also remains under-appreciated as global equity funds maintain an underweight to the asset class. There is a strong argument for diversified investors to allocate to EM equities and the recent weakness presents an opportunity for those who recognise the long-term potential of the asset class.