A re-emergence is under way. The US election thwarted a promising recovery for emerging market equities, after a long bear market. They sold off sharply, giving up almost all their gains from the preceding nine months.
This was one of the most dramatic responses to the Trump victory - money poured out of the emerging world and into the US. A pro-growth US president should be good for emerging markets, but flows of money are critical, and they were directed towards the US.
Exacerbating the problem was the stronger dollar that followed the election. That spurred worries about emerging market currencies, and the risk of crises in Mexico (driven by the election) and Turkey weighed on sentiment.
But now, as US stocks make a second move forward in a second stage of the Trump trade, emerging markets are gaining, both in absolute terms and relative to the developed world. Why is EM on the way back?
One critical difference this time is that the dollar is weaker, in part thanks to jawboning from the US administration. It is questionable whether this can continue if US growth comes through on cue and the Federal Reserve responds with higher rates, but for the time being the risk of a new emerging markets devaluation crisis has been alleviated. Even the Mexican peso, over which many question marks remain, has recovered much ground.
A further factor is that emerging economies are growing again. Indeed according to the Institute of International Finance, emerging market GDP grew 6.4 per cent in January, its fastest monthly growth since June 2011.
As ever, fund flows matter and so far this year they are positive for emerging markets for the first time in four years. In the first week of this month EM funds secured $2.7bn, with exchange traded funds pulling in $1.8bn according to EPFR - their best inflow in six months.
A critical reason for emerging markets’ resurgence is probably China, which appears to have regained its robust appetite for goods from the rest of the world. Chinese demand has long been the key driver of emerging markets. And it remains so. The price of industrial metals suggests a China that is spending again, and helping exporting nations, particularly in Latin America.
China has by far the largest weight of any country within emerging markets indices, and Asia as a whole accounts for more than 70 per cent - an EM investment is more of a bet on China than many realise. However, it is still the case that Chinese stocks themselves are not the best way to capture growth in China, although they have started this year well. Since the beginning of last year, according to MSCI, the MSCI China index, of stocks readily buyable by foreigners, is up 10 per cent, while its A-shares index, capturing the domestic market, has fallen 16 per cent. Meanwhile, MSCI’s index of the 100 developed markets stocks that gain the highest proportion of their revenues from China has gained more than 30 per cent over the same period.
The varied performance of the different emerging geographical sectors makes clear the interaction of the US and China. Materials and mining stocks’s weight in EM has halved during this decade, to about 15 per cent. Latin America, the most commodity-exposed sector, suffered the biggest falls during the bear market, and has enjoyed the biggest rebound - up some 60 per cent from the nadir. But Mr Trump’s combative attitude towards Mexico, drove a sharp correction immediately after the election. Nevertheless, if China avoids a financial accident, and Mr Trump’s reflation trade comes through as promised, it is hard to see how EM can fail to benefit.
The final propulsion behind emerging markets is that they are correctly perceived to be cheap. Research Affiliates’ invaluable asset allocation website publishes calculations of Robert Shiller’s cyclically adjusted price/earnings multiples, which compares prices to average earnings over the previous 10 years. On this basis, emerging markets are cheap, at a multiple of 12, compared to a historic median of 17, and a high of 35.
This is of no help in timing the re-emergence of emerging markets, but it does show that in the long-run, buying them now should pay off. It is seldom a bad idea to buy something when it is too cheap.
