PMC Weekly Review - July 21, 2017

A Macro View: Emerging Markets – Started from the Bottom

One of the main factors driving diversified portfolio returns this year is the strong performance of emerging markets (EM) equities, which are now up 25% this year. Many investors had steered clear of EM for the past few years, as they trailed other assets classes, but in early 2016, the tide began to turn for EM. This shift was highlighted by PMC in the April 15, 2016 Week in Review titled, A Macro View – Guess Who’s Back? EM’s Back. In that commentary, we discussed the factors that precipitated EM’s return and also looked at markets, such as 2000-2009, in which EM outpaced other asset classes by a wide margin. With EM coming off a 12% return in 2016 and a roughly 25% year-to-date return through Thursday, July 20, let’s take a deeper look at the factors driving their success and whether the outperformance will continue.

Through the first six-and-a-half months of 2017, the MSCI Emerging Markets Index has outpaced the MSCI World Index by over 1150 basis points, returning 24.7%, compared with 13.1% for the MSCI World Index. Attractive valuations relative to EM’s developed markets peers, as well as higher economic growth potential, have brought investors back. EM’s gains have been driven heavily by strength in China and South Korea, the asset class’s two largest markets, with EM Asia gaining 29% so far this year. Improved growth in these two countries’ economies, as well as the Technology sector’s strong performance, has contributed heavily to returns. Earlier this week, China reported 6.9% year-over-year growth in the second quarter, topping expectations, and strong retail sales growth of 11% over last year. China’s retail results are quite encouraging for a country that has been transitioning to a consumer-driven economy.

Despite EM’s gains, a potential risk to their recent strength lies with central bank monetary policy. Historically, emerging markets economies have struggled in a rate-tightening cycle, as they are forced to repay debts with a stronger dollar, which raises doubts about the rally’s sustainability. However, emerging markets’ success over the past 18 months has occurred during the first hawkish period for the Federal Reserve (the Fed) in roughly ten years, defying conventional wisdom. Although the expectation had been for a stronger dollar, the dollar has weakened, much due to an improving global economic environment in both developed and developing world countries. This weaker dollar has fostered strength from export-driven economies and countries with high dollarbased debt.

When examining the impact of central bank policy on EM, it’s important to note that with recent disappointing inflation data, a fourth straight Consumer Price Index (CPI) reading coming in below forecasts has resulted in a lower likelihood of another rate hike occurring in 2017, signaled by the Fed Funds Futures falling below 50%. The inflation miss also led to a strong week for emerging markets, highlighting the asset class’s performance not only in spite of the Fed’s tightening but also as investors bought up the asset class on lighter inflation and potentially delayed hawkishness.

Coming off several years of weak results, including losses in 2013-2015, emerging markets equities have had to start from the bottom. But they have battled back and are now one of the best-performing asset classes over the past 18 months. We view EM as an important component for a diversified portfolio and are pleased that the recent results help underscore the importance of diversification. There certainly are risks present for EM, including corruption in Brazil; volatile prices for commodities; China’s shifting economy; and a more hawkish global monetary stance. However, despite the presence of these challenges, EM have shown both their value in a portfolio and their ability to succeed in spite of increased risks.

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Source: Bloomberg

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