Investment Strategy Brief: Emerging Markets Slip
Emerging market equities have delivered whiplash to investors this year, and are now underperforming. We explain why, and what's next.
Emerging market (EM) equities have gone from the best performing region to the worst performing region in a few short months. Are they poised for a comeback or is it time to take a step back? We remain constructive on EM equities. Recent Chinese policy actions have weighed on EM returns, but we are optimistic that they will not reverse China’s strong economic growth trajectory.
A Quick Reversal. Emerging markets went from 2021’s best-performing region through mid-February, when it outpaced global markets by more than 7%, to the year’s laggard through late April, with roughly 5% underperformance. In effect, as emerging market equities started to slide, the rest of the world picked up speed.
It is tempting to look at the region’s continuing battle with COVID-19 as the underlying reason. India in particular is struggling, having just recorded the highest virus case count for any country during the pandemic. However, although negative COVID-19 headlines may have dampened investor sentiment somewhat, it is not the reason for EM equities’ performance reversal. So what is?
Zooming in on China. Since emerging Europe has posted positive returns since mid-February and Latin America has treaded water, the answer lies in Asia. In fact, looking at Asia, it is clear the most important driver has been the Chinese equity market. That market went from being up almost 20% to flat year-to-date. And since Chinese equities account for 37.6% of the emerging markets index (see below exhibit), it has a big impact.
Challenges for Chinese Equities. Two forces have come together to create a formidable headwind for Chinese equities: government policies to head off potential asset bubbles and increased government control over the business sector.
The strong economic recovery from the depths of the pandemic has refocused the attention of Chinese policymakers, in particular the People’s Bank of China, on preventing asset bubbles. They issued warnings on the rise in equity markets and home prices and very modestly tightened policy by draining liquidity. And although the overall policy stance is closer to neutral than tight, investors reacted negatively.
Further, China’s government is increasing control of the business sector, in particular high-flying technology companies. The government wants to ensure its strategic priorities take precedence over short-term profits. Headline IPOs have been delayed, regulatory oversight has been intensified and investment plans are scrutinized closely, all in the name of ensuring that the businesses are serving China’s long-term goals.
Market Implications: Careful management, cautious optimism. Although we don’t expect the Chinese government will loosen its control over the business sector, we do expect the government to establish a new working relationship with business that will allow tensions to dissipate. Also, we don’t think the government will tighten fiscal and monetary policy enough to hold back the economic recovery. Instead, we think the Chinese government is carefully managing the risk of an overheating economy. As a result, we remain cautiously optimistic about the prospects of the Chinese equity market and by extension the emerging market equity region, in which we hold a small overweight in our tactical asset allocation.
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