India and South Korea show emerging markets offer alternative to US, China economic doom and gloom
September 15, 2023
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Many institutional investors believe emerging markets have the worst of both worlds. The US economy – particularly its resilient labour market – is too strong, forcing the Federal Reserve to keep interest rates at high levels and potentially necessitating additional tightening. This has driven up yields on US Treasury bonds, which has contributed to the steep rise in the US dollar and put emerging market assets under strain.
Developing economies are also having to contend with a loss of confidence in China’s economy as growth slows sharply and concerns intensify over Beijing’s reluctance to deploy aggressive fiscal stimulus measures to stop the rot in the property sector. With China accounting for about 30 per cent of the benchmark MSCI Emerging Market equity index and developing economies – especially commodity exporters – most exposed to the slowdown in China, the spillover effects are significant.
For an indication of the extent to which uncertainty over US monetary policy and China has undermined sentiment, look no further than the findings of Bank of America’s latest global fund manager survey, which was published on Tuesday. Respondents cited high inflation that keeps leading central banks hawkish as the biggest “tail risk” in markets, underscoring the lack of conviction among investors over the timing of rate cuts despite signs the US economy is slowing.
Furthermore, respondents’ expectations about growth in China plunged to their lowest level since widespread lockdowns were in place last year.
Just as worryingly, China’s property sector supplanted US real estate – in particular the vulnerable office market – as the most likely source for a “systemic credit event”.
Yet, if concerns about a hawkish Fed and a sharp downturn in China have caused developing economies to fall out of favour with investors, why is an exchange traded fund tracking an index of emerging market stocks that excludes China up 8.2 per cent this year?
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According to a report published by Goldman Sachs on August 21, part of the reason might be because the spillover effects of downward revisions to forecasts for Chinese economic growth and corporate earnings have waned. This suggests “there is a slow divorce occurring between China and the rest of [emerging markets’] growth prospects”.
This is debatable, particularly given the sharpness of the sell-off in emerging markets since early August. Although worries about the Fed’s hawkish stance are largely to blame, the property-driven downturn in China is clearly a factor.
However, it is not all about the Fed and China. The Nifty 50 Index, one of the key gauges of Indian stocks, is up more than 18 per cent since mid-March. According to high-frequency data on fund flows from JPMorgan, foreign investors have purchased nearly US$16.5 billion of Indian equities this year.
While there are concerns about the lofty valuations of Indian stocks – which have a 15 per cent weighting in the benchmark MSCI emerging markets index – they continue to benefit from a fast-growing economy, strong corporate earnings and, crucially, India’s appeal as an alternative to China.
South Korea is another market that has outperformed the broader index. Although the global semiconductor industry is in the midst of a downcycle, the hype around generative artificial intelligence has lifted sentiment towards South Korea’s technology-heavy stock market, which is up more than 13 per cent this year. Goldman Sachs believes Korean equities will continue to outperform, especially if the United States enjoys a soft economic landing.
Mexico is already benefiting from strong trade links with the US economy. Earlier this year, it supplanted China as the largest US trade partner as Washington seeks to reduce supply chain reliance on geopolitical rivals and source imports closer to home. The rise of “nearshoring” has steered Mexico into a geopolitical sweet spot, supported by the government’s prudent fiscal and monetary policies.
Furthermore, many emerging market central banks were ahead of the curve, raising interest rates long before the Fed began to tighten policy aggressively. With inflation now falling more sharply than in developed economies, this has created space for rate cuts.
Several major emerging markets, including Brazil and Poland, have already reduced borrowing costs. More are expected to follow suit in the next few quarters. By leading the global rate-cutting cycle, developing economies will be in a better position to cope with slower growth, provided they are financially stable enough to cut rates.
Emerging markets still face plenty of headwinds. Oil prices are rising again, hitting their highest in 10 months. This is fuelling inflationary pressures and hitting net importers of energy such as India.
Sentiment, moreover, remains grim. Even if plunging Chinese stocks and surging US shares are excluded, emerging-market equities are still performing poorly against their peers in advanced economies.
Even so, there are grounds for cautious optimism. Not only are emerging market stocks trading at a 31 per cent discount to developed market shares, global investors are still “massively under-positioned” in developing economies, according to JPMorgan. If China’s economy stabilises or if the Fed makes it clear it is done raising rates, emerging markets could bounce back.
While there are risks aplenty and it has been two decades since developing economies enjoyed a multi-year bull market, it is not all doom and gloom.