Emerging market equities have had a difficult year. They have been struggling since mid-February after a strong start, falling by more than 10 per cent, while developed market equities have risen by around 10 per cent. What has gone wrong, and when might it get better?
The first thing to note is the dominance of Asia
in the emerging market equity universe, with China accounting for more than a third of its equity by value. Adding in the markets of South Korea, Taiwan and India, the number is closer to three-quarters.
It is therefore of little surprise that the first signs
of a slowing Chinese economy
started the trouble for emerging market equities back in February. This was not totally unexpected, given that China was the first major economy to recover from the pandemic-induced recession and thus was likely to be the first to normalise from the rapid, reopening-driven growth.
Furthermore, Chinese policymakers had already started tightening economic policy
in an effort to rein in excesses in the financial system and the real estate sector. Soon after, China’s began its ongoing regulation drive in the technology sector, which naturally has hurt the share prices of the affected companies in recent months.
The tech crackdown
has been a significant drag on markets overall, as it directly affected some of the largest companies in the mainland Chinese, Hong Kong and emerging market equity indices. Most recently, the tightening of policy in the real estate sector has come to a head, with the much-publicised troubles
for companies in that sector.
While this is unlikely
to lead to a full-blown crisis, and could even turn out to be healthy for the economy in the long run, there will almost certainly be a price to pay in terms of near-term growth. It has certainly added to the pressure on Chinese equities.
Adding to the region’s difficulties, Taiwan and South Korea, the two next-largest emerging Asia equity markets, have also struggled for much of this year. This is in marked contrast to their stellar performance in 2020.
Markets in both countries are dominated by a few companies in the technology sector, semiconductor manufacturers
in particular. These products have been in huge demand amid the much-discussed global supply chain issues this year.
However, this industry tends to be hugely cyclical, swinging back and forth between boom and bust over the decades. Some worry that this current semiconductor cycle has already peaked, although the jury is probably still out.
The one ray of light in the region has been India’s equity market, which has rebounded strongly
as the country has slowly recovered from its huge Covid-19 outbreak. But, on its own, India’s stock market is not large enough to meaningfully bail out emerging market equity investors.
Global investors are wondering when it will be time to buy back into the emerging market story. One key consideration is whether valuations are now cheap enough after the period of share price falls. Unfortunately, valuations are in something of a no man’s land – no longer outright expensive, but still well above levels when investors say “just close your eyes and buy”.
For instance, the 12-month forward price-to-earnings (PE) ratio for the widely used MSCI emerging market equity index is just below 13. While this is almost perfectly in line with its average of the past 30 years, it is still well above the lows reached in previous periods of Chinese macro worries
. In 2015 and 2018, the PE fell to around 10, or another 30 per cent down from its current level. The numbers for Chinese equities look similar.
One issue for emerging market equities is that there are other regions with a clearer outlook. For example, Europe and Japan also offer much-improved valuations with strengthening economies.
So, with valuations not yet providing a strong case, what might turn things around? As it happens, better days in emerging market equities could be triggered by the current economic woes in China.
Chinese equities, in particular, are very much driven by the amount of economic stimulus
applied by policymakers. If the current slowdown in the Chinese economy
continues to worsen, policymakers could significantly loosen policy again.
That might end up helping the parts of the economy that policymakers would prefer to de-emphasise. Nevertheless, Chinese equity markets would probably cheer such a turnaround, and so would the rest of emerging markets.
Patrik Schowitz is a global multi-asset strategist at JP Morgan Asset Management