1990s alt-rock sensation Garbage were the product of years of patient effort among their four original members. They were the archetypal rock latecomers, aged 42 (Duke Erikson), 40 (Butch Vig), 36 (Steve Marker) and 29 (Shirley Manson) when they finally made it. Emerging market (EM) equities have felt stuck in a similarly prolonged ‘hustling’ stage; the potential is all there but the figurative breakthrough album has still not been produced.
Covid-19 and the response to it have only made that day seem even more distant for EMs, exacerbating structural and cultural features that have conspired to hold back emerging economies and equity markets relative to their developed counterparts. Investors are right to question how long they will realistically need to wait for the breakthrough, if indeed it is coming at all.
EM equities face three particular headwinds. First, central banks globally are feeling pressurised to tighten interest rates amid rising inflation. Brazil has increased its main lending rate three times this year alone to deal with inflation and it now stands at 4.25%, which is where it was in early 2020. Amid a pandemic which Brazil’s healthcare system is struggling with, this tightening is unsurprisingly hurting economic activity and feeding into underperformance of the Bovespa Index. Similarly unappetising policy choices face many other emerging economies.
Expectations of higher US interest rates are also problematic for EM equities as the prospect of higher rates in the US attracts global capital and places upward pressure on the US dollar. This is important because, thanks to a process of ‘dollarisation’ over the years, a high proportion of both global trade receipts and EM debt issuance is denominated in US dollars. Today’s US dollar strength is exerting a tremendous tightening pressure on economic activity in EMs.
The second headwind has been Chinese regulatory intervention. The authorities have been cracking down on the tech sector for some time now but the latest edict to ban educational firms from making profits in tutoring core subjects has alarmed investors. This aggressive approach reflects the more robust tone set by the Chinese leadership generally of late. Given China represents over a third of the MSCI EM Index, the prospect of a partially functioning Chinese equity market has quite rightly dragged down the EM complex as a whole versus its developed market peers.
Third is the spectre of continued Covid-19 infections across an economic block with generally low vaccination rates. EMs by their nature are more contact-sensitive as the potential growth of economies built around ideas and intellectual capital – taken for granted in the West – is still in the process of being realised. Vaccinations are the obvious way to unlock this unhappy situation but, according to the World Bank, the world’s poorest 29 economies have only given one dose of the vaccine to 0.3% of the population.
Crucially, all of these challenges have a certain transience about them which long-term equity investors can rightly be expected to sit out. There is unlikely to be any near-term fix to the global dominance of the US dollar but a natural slowing down in the post-pandemic recovery, as well as some caution around the Delta variant of Covid-19, has seen long-term US growth expectations as measured by real bond yields fall. While any Covid-19 resurgence is hardly welcome, a cooling of the US economic expansion could well give EMs the breathing space they need by making the US dollar a little less attractive to global capital.
Turning to China, local investors have not been deterred by the recent market interventions, taking out margin loans to buy equities that foreigners were so keen to dispose of in recent weeks. This reveals the faith in the market leveraged investors have, that they are prepared to buy the dip despite incurring borrowing costs too. Perhaps these investors have noted that valuations have become relatively attractive as a result of the panic, with China’s technology sector in particular now looking like good value versus global peers.
From a broader perspective, an equity market that has undergone a recalibration to align with the long-term objectives of the party leadership on issues like wages (logistics sector), accumulation of executive power (tech sector) and youth policy (education sector) is surely better positioned to deliver sustainable returns. China’s equity markets represent only 5% of the MSCI AC World Index but nearly 20% of the global economy. This, along with the authorities’ firm view that ‘guided’ markets should play a bigger role in the efficient allocation of capital in China, should provide reassurance that the country remains a vital part of any portfolio.
Finally, on vaccination in EMs, there are belated signs of progress. Singapore, China and Hong Kong are starting to make headway in terms of meaningful vaccine penetration, while initial horror at what was seen as premature reopening in the US and UK may give way to a profound policy reassessment among emerging economies relying heavily on a strict zero-Covid-19 policy that is delaying re-opening and recovery. There may be a silver lining for EMs if certain countries demonstrate that only vaccinations can facilitate proper reopening and the abandonment of economy-strangling social restrictions.
The long-term case for EMs remains rock solid, in our view. Investors should not be put off by what has been a perfect storm for the asset class in the form of a strong US dollar, Chinese regulatory intervention and a controversial Covid-19 response. These are likely to give way as the US economic recovery naturally cools, China completes the planned re-alignment of its corporate culture and vaccinations finally start to replace social restrictions as the main defence against Covid-19 deaths. If this was the history of the band Garbage, it might just be the moment when Shirley Manson was chosen for the role of lead singer.
Julian Howard is the lead investment director of multi asset solutions at GAM. The views expressed above are his own and should not be taken as investment advice.