Bolstered by China, emerging market equities have potential for resilience amid US recession risks

Emerging market stocks have had a lacklustre year so far compared with developed markets. However, the Chinese economy is still on the path to recovery, with policy easing looking increasingly likely

Sylvia Sheng

Published: 10:30pm, 2 Jun 2023

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Emerging market equities’ year-to-date returns have lagged behind those in developed markets. This divergence has occurred despite a rally in global equities, a weaker US dollar and strength in the Chinese economy, which usually provide a fertile backdrop for emerging nations’ equity markets to outperform.

Two main factors have driven the lacklustre performance so far this year. First, developed economies have held up much better than many had expected at the start of the year. This is especially so for the US economy, which has remained resilient in the face of aggressive monetary policy tightening by the Federal Reserve since last year.

While US headline first-quarter gross domestic product growth fell short of market expectations, it was mainly dragged down by a decline in inventories. Domestic final sales, which is a better gauge of underlying US domestic demand, jumped 3.3 per cent at an annual rate, the strongest performance since the second quarter of 2021, led by household consumption. Recent labour market data also pointed to continued strength, with strong payroll employment increases in April and the unemployment rate at multi-decade lows.

In Europe, the natural gas crunch during winter was less harmful than seemed likely due to a combination of LNG imports and mild weather. As a result, private-sector sentiment has improved in recent months helped by falling gas prices.

Meanwhile, economic recovery in Japan is gathering strength, driven by a rebound in private consumption amid improving wage momentum.

Second, the strong post-reopening recovery in China has generated limited positive spillovers in the rest of emerging market economies. Since reopening in January, China’s economic recovery has been mainly led by a rebound in services consumption as pent-up demand is released, while manufacturing activities have remained weak, as reflected in the May’s purchasing managers’ indices.

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While the worst of the China property downturn appears to be over, incoming home sales data is more consistent with a stabilisation of property-sector activities at low levels, rather than a modest recovery indicated by the surge in the first quarter. Given the weakness in industrial goods demand, there has been no significant pickup in China’s import demand, especially for commodities, limiting China’s support for other emerging market economies through the trade channel.

However, the relative growth differential is likely to turn more favourable for China compared to the US. While the easy part of the post-reopening recovery seems to be over, the Chinese economy is still on a recovery path.

Looking ahead, continued service-sector recovery should help drive a gradual growth in employment and incomes. A further improvement in consumer confidence is likely to bring about a partial release of excess savings to support consumption recovery.

Sustained policy support holds the key to further economic recovery. Policy discussions have quickly turned from worries about early tightening, following the better-than-expected first-quarter data, to expectations of easing after the recent slew of weak data.

A food delivery driver sits outside a restaurant at a shopping mall in Beijing. Photo: AFP

Should economic growth lose more momentum, Chinese policymakers are likely to roll out additional easing. With banks lowering deposit rates amid weak inflation, there is a rising likelihood of a small lending rate cut. A further loosening of property policies is also likely in response to recent weakness.

Meanwhile, in the US, while growth momentum looks fine for now and household consumption remains firm, we are seeing more cautious business behaviour, probably reflecting weaker sentiment.

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Demand for capital investment appears to be slowing. Equipment investment fell for a second quarter in a row in the first quarter and investment in intellectual property decelerated. A similar picture can be seen on the labour demand side, with the total number of hours worked cooling and a slight pickup in lay-offs, as seen in jobless claims.

An increase in cautionary business behaviour, leading to a further pull back in demand for labour and capital investment, could push the US economy into recession.

Amazon employees and supporters gather during a walkout protest against recent lay-offs, a return-to-office mandate, and the company’s environmental impact, outside Amazon headquarters in Seattle, Washington, on May 31. Photo: AFP

Moreover, disruptions as a result of the US regional banking sector turmoil have not completely gone away. On the positive side, emergency lending from the Fed has stabilised, suggesting stress in the funding market has largely subsided. However, credit conditions are likely to tighten as regional banks repair their balance sheets, and the associated negative impact on the US economy will take longer to show up.

History tells us that emerging market equities usually struggle when the US economy goes into recession. However, there is meaningful divergence of growth outlook, with risks appearing greatest in the US, while China’s cyclical recovery has more room to run. Therefore, there is potential for resilience in emerging market equities, anchored by a favourable macro backdrop in China.

Sylvia Sheng is a global multi-asset strategist at JP Morgan Asset Management

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