Emerging markets have struggled this year following strong performance in 2017 as the asset class has faced several headwinds.
A strengthening dollar amid an ongoing rate hiking regime pursued by the Federal Reserve has put increased pressure on emerging market economies, given that much of their borrowing is in dollars.
Following the latest meeting of the rate-setting Federal Open Market Committee, Fed chair Jerome Powell said the central bank has been transparent about its hiking programme despite the negative impact for emerging markets.
“There are some countries that are undergoing severe stress, a handful of them, but not most emerging market countries,” he said.
“It’s a relatively small number, and those particular countries have particular vulnerabilities, which are well known in the form of budget deficits, and significant external dollar borrowings, and high inflation, and things like that.
“We’ll continue to conduct US monetary policy as transparently as we possibly can and that’s really the best thing we can do, along with supporting US growth.”
At the same time as the dollar has strengthened, however, there have been ongoing concerns surrounding the potential for a full-blown ‘trade war’ as US president Donald Trump has pursued a tougher stance with allies and rivals alike.
One target has been China, the largest emerging market economy, which the US has hit with a series of tariffs during the course of the year.
The ongoing spat has dampened investor sentiment and – as a result – Chinese equities and the benchmark have struggled so far in 2018.
Performance of indices in 2018
Source: FE Analytics
Indeed, the MSCI Emerging Markets index has fallen by 10.77 per cent – in sterling terms – so far in 2018 compared with a 3.43 per cent gain for the developed markets-focused MSCI World benchmark.
It could take some time for emerging markets equities to outperform their peers in developed markets despite starting from a lower base, according to Capital Economics’ Oliver Jones, who noted that the valuations gap between the MSCI Emerging Markets and MSCI World is large by recent standards.
“A widely-cited argument is that emerging market equities are now relatively ‘cheap’ and that they are likely to deliver much larger returns than their developed market peers next year as the gap in valuations reverts to more normal levels,” said the market economist.
However, Jones said such a reversion “typically takes a long time” with a variety of factors likely to impact returns in the meantime.
“So, there is only a tenuous relationship between the relative valuations of the MSCI Emerging Market and MSCI World indices and their performance over the next year,” he explained.
While investors might point to the gap in valuations relative to performance over longer time horizons, said Jones, the link might not be as strong as they think.
“When the gap in price/earnings ratios has been as large as it is now, the MSCI Emerging Markets index has outperformed over the next five years too, but only by a fairly small margin – more like 1-2 per cent – on average,” he explained.
“And on a few occasions, it has actually fared a lot worse than the MSCI World index over the following half-decade.”
Performance of indices over 5yrs
Source: FE Analytics
Jones added: “Although the valuations of emerging market equities have tumbled compared to those of their developed market peers, we are not convinced that they will deliver much higher returns over the next year as a result.
“There is more evidence that they might outperform over the next five years, though.”
However, Ashmore Group head of research Jan Dehn expects the dollar to resume its decline in 2019, supporting emerging markets next year “after a period of interruption in 2018”.
The Ashmore Group research head said US fiscal and trade policy have been designed to help boost Republicans win the upcoming mid-term elections and are likely to prove temporary interruptions.
“After all, the US fiscal stimulus will fade and trade policies only impose more and more costs on US businesses,” he explained.
“Against this backdrop, we expect the dollar to resume its decline in 2019 accompanied by stronger emerging markets, but possibly now also accompanied by a worse performance for US stocks.”
Additionally, US policymakers are becoming increasingly aware of the impact that a stronger dollar will likely have on the domestic economy.
US dollar strength vs the trade balance over 10yrs
Source: St Louis Fed
As the above chart shows, the strong dollar – as represented by the trade-weighted dollar index – has coincided with more subdued demand for goods and services, as shown by the trade balance-to-trade volume ratio – the difference between exports and imports as a share of total trade.
As Fed chair Powell noted last month, the impact of a stronger dollar is likely to be felt – sooner or later – by the domestic economy.
“We serve a domestic mandate and that is to have maximum employment and stable prices. And way more than half of the growth is outside the US and in emerging markets,” said Powell. “So, the performance in the emerging market economies really matters to us in carrying out our domestic mandate.”
Yet, while there is potential for a turnaround in emerging market equities the outlook remains as clouded as ever.
“The outlook for emerging markets is complex,” noted the Nikko Asset Management multi-asset team.
“We had hoped growth momentum slowing in the US and returning elsewhere would ease dollar strength. However, China easing against US tightening, coupled with renewed European concerns in the form of Italy remaining defiant on fiscal budgets, continue to support the dollar.”
The team added: “Emerging markets are unambiguously cheap, but policies and their impact on the growth outlook will remain key determinants of earnings and therefore market direction.”