One of the first lessons learnt in fund management is the uncanny knack of stock markets to surprise. This year has certainly been a case in point.
In an environment that has seen the UK vote to leave the European Union, persistently low economic growth, ongoing pressure on corporate profitability, extraordinary monetary policy and the threat of Donald Trump being elected as US president, it would not have been unreasonable to forecast a year of poor returns. Instead, global stock markets have risen 6.6% this year in dollar terms, and were up 5.3% over the quarter. Stock markets in the US, Europe and Japan returned 4.0%, 5.4% and 8.6%, respectively, during the quarter. Bonds also performed well, with global government bonds returning 0.4% and corporate bonds some 1.9%. Most dramatically, emerging market (EM) equities have experienced a sharp rebound. The region as a whole returned 9.0% over the quarter and 16.0% year-to-date, with exceptional performances this year from countries such as Brazil and Russia, which are now up by 64.1% and 30.9% respectively. We look at the prospects for EM in more detail below.
Chart 1: Performance in USD
To understand the drivers behind this year’s market performance we must consider the rather peculiar global backdrop in which we live.
We entered the year having seen the first US interest rate rise in almost ten years and the market anticipating four further rises as we moved through 2016. This was a really big deal. In recent years markets have been lifted higher by a tide of liquidity, as low interest rates and quantitative easing have been the weapons of choice for central banks and governments around the world in their efforts to kick-start economies following the global financial crisis. The belief that this party was coming to an end caused panic at the start of the year, especially as this cycle was already looking rather long-in-the-tooth.
Quite quickly, however, it became obvious that the US Federal Reserve was not in a position to normalise rates. With growth continuing to disappoint, weak stock markets and the rise of geo-political risks all served to stay the Feds hand. In other regions this year, including Europe, the UK and Japan, interest rates have been cut and further QE introduced. Hence just as quickly as it was removed the liquidity trade was put firmly back on the table, and with a backdrop of equities looking cheap versus bonds (although we would argue it’s actually a case of bonds being expensive), markets have been driven up once more.
Chart 2: Dividend yield minus bond yield
The strong performance in emerging markets this year raises some important questions. On the one hand this could be put down to the turbo-charged nature of these markets, which typically underperform developed markets in a bear market and outperform in a bull market. More significantly, though, one wonders if this recent outperformance is a reassertion of the structural trends that drove the supernormal EM returns in the late nineties and early 2000s.
To help understand this performance and the outlook for the region, it is useful to break down the performance into three distinct waves:
Chart 3: The three waves of emerging market performance
Clearly the late nineties up until the global financial crisis represented a purple patch for the region. A multitude of factors came into play but central to this was the globalisation in world trade and China’s role within this. Through this period China was experiencing a step change in its evolution both from a political and trade perspective. This occurred at a time when the West fervently believed in the benefits of global trade and the wealth benefits to all from shifting manufacturing to low cost regions such as China. Through urbanisation, as workers moved from agriculture to working within cities, EM exports boomed and commodity prices spiked, boosting the exports of those EM nations which were commodity producers. Underpinning this performance the trend of lower interest rates saw surplus capital from the West flooding into EM, boosting capital expenditure and encouraging investment.
EM valuations, having historically been much lower than those in developed markets, rose such that at their peak they were above those of the developed markets.
Chart 4: Emerging market versus developed market valuations
Unfortunately, during the second wave, post the global financial crisis many of the factors that had been driving EM performance stalled. EM exports were dented by the sluggish global recovery as economies came out of recession, resulting in a sharp slowdown in global trade. Partly this was a cyclical phenomenon, but more pertinently it may reflect a structural peak in globalisation. Political rhetoric has clearly shifted towards viewing global trade in a more mixed light. There has been a marked rise in protectionist sentiment with competitive currency devaluations, and the question has been raised as to whether or not globalisation benefits developing market populations at the expense of those on lower incomes in the West.
China’s economic position has also deteriorated. Having experienced unparalleled levels of growth over the past decade, investment levels boomed, resulting in the misallocation of capital and bubbles forming. Combined with a rapidly ageing population, exacerbated by the one child policy, Chinese growth rates have slowed.
This brings us to the current wave and the question of whether or not the recent outperformance merely represents a period of respite in a broader decline or something more durable.
In the near term we view the current recovery as having some legs. Global growth, whilst rather lacklustre, represents a potential goldilocks scenario of being neither too hot nor too cold – that is, global growth is sufficiently strong to benefit EM growth but not so strong that we see an aggressive turn in the interest rate cycle. The future path of interest rates is particularly important, with it being very unlikely that the EM region can make significant headway against a backdrop of sharply rising rates.
There is also an argument that EM valuations can play catch-up with those in the developed markets with the more mature phases of stock market cycles characterised by momentum and the purchasing of those stocks and sectors that have been laggards. With investors typically underweight the EM space, this should help ensure that prospects continue to improve, at least in the near term.
Longer term, though, we would suggest caution. Whilst, as highlighted above, there are a number of cyclical factors at play that may sustain the rally, the structural challenges have not gone away. Globalisation remains under pressure in the current climate, which is concerning for a region that is reliant on open economies and global trade. China is exhibiting all kinds of worrying distortions with the government appearing to have a low tolerance of poor growth and is engaging in the same type of bad medicine that caused the distortions in the first place. Equally, we expect the commodity super-cycle is unlikely to rebound quickly with such cycles tending to operate on timescales of decades rather than years. It would be wrong to think that we will return to the glory days of the nineties any time soon with trend growth for the EM region likely to be lower in the future.