Despite one of the sharpest rallies in US equities in recent memory, emerging market equities have been left curiously behind in 2013. Through last Friday, the market segment was down 1.0%, compared to an S&P 500 index that was up 10.0%. This seems to violate the regime that investors have gotten used to over the past 10 years, whereby the emerging markets equity index served as a high beta proxy for the US equity market.
So what exactly is going on with emerging markets stocks? Amid an environment of reduced fear, and seemingly much worse structural problems in developing economies than emerging, it is reasonable to question why these markets are failing to participate.
A look at the underlying components of the index does not reveal any undue influence from a particular market segment. While the BRIC countries that dominate the index have not performed particularly well – Brazil (+1.5%), Russia (+1.6%), India (+1.0%), and China (-3.6%) – neither have most of the other 17 countries in the MSCI index. Outside of a few outliers, every country index in the benchmark has a 2013 return of less than 5%; 11 of the benchmark’s 21 member countries are in negative territory.
Currency is not a factor either, at least on the aggregate. The emerging markets index has seen a modest detraction of 69 bps from appreciation in the US dollar. Eastern Europe saw the biggest headwinds from this effect, with the Europe, Middle East, & Africa (EMEA) segment’s return reduced by more than 3.5%. On the flip side, strength in the Brazilian real and the Mexican peso has caused the Latin American sub-index to see a 3.1% tailwind. Asian currencies were mixed.
One potential explanation for the weakness in EM equities is that as investors move out on the risk curve – from investment grade bonds to high yield to equities – they have done so only incrementally. This may particularly be the case for those shell-shocked investors from 2008 who are just beginning to dip their toe into equities. US stocks are the natural starting point for that demographic.
The concerns that plagued emerging markets in 2011 may also be resurfacing – namely, inflation. With developed central banks showing increasing commitment to easing policies, many are justifiably worried that they will end up exporting this inflation to emerging markets. China is often the focal point on this front, and the country’s latest inflation print was cause for alarm. At 3.2% year-over-year, inflation is at its highest level in a year and represents a steady uptrend since last fall, when it troughed at 1.7%. Other countries including Brazil, India, and Russia have seen inflation on the rise so far in 2013.
Emerging markets central banks aren’t doing much to help the cause. They, like their developed counterparts, continue down a path of unprecedented interest rate cuts and other easing policies. In 2012, emerging markets central banks cut interest rates by a combined 1,126 bps, compared to 400 bps in developed markets (according to centralbanknews.info). The pace of rate cuts is slowing somewhat in 2013, but a fifth of the 102 policy decisions made by global central banks this year (primarily emerging market economies) have been rate cuts.
Economic growth has been okay, if unspectacular. Still, compared to Europe, which is in recession, and the US, which is middling, the region looks relatively more attractive. The IMF expects the group to grow by 5.5% in 2013, but not for it to resume the levels of growth witnessed in 2010 and 2011. The IMF’s most recent World Economic Outlook noted, “supportive policies have underpinned much of the recent acceleration in activity in many economies. But weakness in advanced economies will weigh on external demand, as well as on the terms of trade of commodity exporters, given [our] assumption of lower commodity prices in 2013.”
To the extent that emerging markets are viewed as a proxy for commodity exposure, this may be an additional reason for underperformance in 2013. Through March 15, the Dow Jones-UBS Commodity index was down 0.5%, with weakness in metals and agriculture driving the loss. Energy is performing somewhat better, up 5.0% on the year, but a poor February pulled all commodity sectors lower. Soft import and PMI data from China was blamed partially for the pullback. While the cyclical composition of the MSCI benchmark is lower now than at the end of 2007, when energy and materials made up one-third of the index, those two sectors still comprise 23% of the index today.
Whatever the reason, emerging markets are clearly the global laggards this year, failing to keep pace with either the US or developed international stocks. From a valuation perspective, emerging markets remain reasonable, trading at 12x price-to-earnings, according to Bloomberg data. That compares to a 15.4x average since 1994.
With recent flare-ups in developed markets, including the potential election debacle in Italy and the Cyprus situation (not to mention the US’ own structural deficit issues), it will be interesting to watch how emerging markets are treated by investors moving forward. There have long been calls for emerging markets to decouple from developed ones as the countries’ economic infrastructure matures and their healthier fiscal status is recognized, but that has not yet come to fruition. Emerging markets appear to have decoupled this year, but not in the way that investors were hoping.