Investment Week - Asset Allocator’s Soapbox
Recent financial market movements have once more belied the notion that emerging markets can decouple from the malaise seen in the developed economies. Year to date, emerging market (EM) equities have been a significant underperformer versus their developed market counterparts, such as US shares. It serves as a timely reminder that emerging markets often exhibit a high beta, or risk, in times of market stress, demonstrating considerable volatility that should make investors wary.
Following on from the shocking collapse of Lehman Brothers back in 2008, and the subsequent unwind of leveraged carry trade positions, we saw a sharp underperformance of EM asset prices. Equities, bonds and currencies suffered alike, even those that had hitherto been regarded as some of the soundest globally, such as Brazil with its recently attained investment grade status. The Brazilian Real currency for example, fell from around R$ 1.60 to the US$ in early 2008, to a low of almost R$2.50, a quite stunning depreciation of close to 60%.
What we now know is that there was a great amount of leverage in many EM positions. When things went badly wrong in the financial system and liquidity dried up, many sellers ‘ran for the exit’ at the same time. This created major distortions in terms of asset prices.
After the dust settled and a period of normality came back into markets, if one can call a buying spree induced by quantitative easing ‘normality’, investors were inclined to pick up good EM assets that were trading at distressed valuations. Indeed they felt compelled to buy in good size. Bellwether EM currencies enjoyed a sustained rally; the Brazilian Real reached a new high against the US$, more than completely retracing its steps. Brazilian policymakers were even moved to bring in a range of capital controls to try to prevent excessive currency appreciation, such was the buying fervour seen as recently as late last year. Emerging market equity markets, similarly, rallied substantially from their late 2008 lows, with the MSCI GEM index up even as of today by some 100%, in spite of recent sell offs.
Investor memories can be short. Late last year, and to some extent still earlier this year, it become fashionable once again to speak of emerging markets having decoupled from the developed world’s macro malaise. After all, hadn’t China and India managed to grow their GDP strongly, in nominal and real terms, right the way through this crisis? The answer is a resounding yes, and with the two pre-eminent emerging markets growing strongly, investors’ appetites were once more whetted by the prospects of a lot of upside beta, without so much of the downside risk.
Sadly, however, this year has proven to be, once again a nasty reality check. Emerging market equities, by mid September this year had fallen by close to 15% in US$ terms. Although they have fared better than mainstream European equities, they have substantially underperformed the S&P500, the main US benchmark, as well as other key markets such as the UK or Japan. Furthermore, by this point they had also underperformed the MSCI World, which is the blended index of developed country indices. This lends itself to the conclusion that emerging markets retain their high beta status. Even though emerging markets do exhibit a range of structural characteristics that would suggest their likely outperformance, history is replete with examples of emerging markets disappointing in terms of their financial markets’ performance when the going gets tough.
The recent wave of crises emanating from the Eurozone are a perfect case in point. It is very clear that emerging markets were most definitely not the key driver of the systemic frailty evident in global equity markets of late. A strong case can easily be made that this year in particular, emerging markets should have outperformed, given their clear balance sheet superiority. However, a common aversion to taking risk and the predominance of overseas as opposed to domestic investors in such markets are clearly primary factors. That emerging markets have not, thus far, managed to outperform in this context, does not bode well for those positioning hopefully for a decoupling of emerging markets from the global cycle. Perhaps such optimists will enjoy better luck next time!
Jason M. Hepner, CFA, Investment Director, Global Strategy, Standard Life Investments
First Published in Investment Week 06th October 2011