Author: NN Investment Partners
Good prospects for domestic demand growth should help emerging market equities continue their outperformance trend.
Emerging market equities have held up quite well in the face of recent turbulence in global markets. Good prospects for EM domestic demand growth should help maintain their outperformance trend.
Remarkable resilience in emerging markets
Emerging equity markets usually tend to struggle during sharp global equity market corrections, particularly those driven by inflation worries and rising bond yields in developed markets.
A market-wide risk-off stance usually means aggressive selling in EMs, especially in those with the biggest macro imbalances and the highest foreign capital needs.
During the most recent global equity market correction, EM underperformed DM, but not by much. What’s more interesting is that the traditional weak links like Turkey, Brazil and Colombia were not responsible for the underperformance and even outperformed the EM average.
The only emerging market that clearly underperformed in the past weeks is China, which is not surprising in view of the state of investor positioning and the country’s strong outperformance in the preceding months. During that time, the Chinese market, especially the internet sector, had inflated the most among emerging markets.
A far bigger surprise was the relative outperformance of the EMs that are normally more sensitive to big movements in DM interest rates, given the general consensus that inflation worries and rising bond yields triggered the global equity sell-off.
When measured within short timeframes, markets do not always move in tandem, and consistency between market segments can be ambiguous. A Fed re-pricing and rising DM bond yields can hit equity markets before they materially affect credit markets.
Rising DM yields may also create enough nervousness to deflate the hottest market segments, such as Chinese internet stocks, but more inflation worries and higher yields may be needed for the more fundamentally challenged markets to be hit.
Domestic demand growth recovery likely to continue
Inflation worries are not likely to disappear suddenly, and markets could easily price more Fed rate hikes. The countries with the biggest macro vulnerabilities and highest foreign capital needs are likely to come under more pressure.
For EM space as a whole, DM rate dynamics are less of a problem. Aggregate macro imbalances and foreign capital requirements are lower than they used to be, and following years of weak growth and currency depreciation, the right ingredients are in place for a sustained domestic demand growth recovery in most emerging economies outside of China.
This recovery already started last year and is likely to continue. Financial conditions are still easy. Low, stable inflation throughout the emerging world gives the region’s central banks room to cut rates, or at least to avoid aggressive hiking. This helps explain the improvement in EM capital flows in the past few quarters.
Capital flows improve
Foreign exchange and trade data for January indicate that it was the best month for broad EM capital flows since 2013. The overall picture is one of good prospects for domestic demand growth, despite recent signs of softer EM growth momentum. Credit growth ex-China continues to pick up. For China itself, the macro picture is one of stable growth and declining financial system risk, which has also contributed to EM’s recent resilience.
Domestic demand prospects bodes well for EM performance
As long as the rising bond yields in the US and Europe do not force EM central banks to tighten policy, and as long as that keeps EM financial conditions easy, the EM domestic demand growth recovery should continue and the EM-DM outperformance trend in equities that started two years ago should be sustained.