It is risk-on time for emerging markets. Last week’s sovereign bonds from Argentina and Russia confirm it. Both came from creditors not usually regarded as safe or secure, yet both were amply oversubscribed and both have traded strongly on secondary markets.
For some observers, such investor enthusiasm is a sure sign that the EM recovery is getting frothy. But there may also be reasons for investors who have tended to view EMs with suspicion to think again about the asset class.
The EM recovery is not new. It began in January 2016 when, after five years of straight decline, EM currencies began making ground against the US dollar and EM stocks began once again to outperform their developed market peers.
There are two sides to both stories. EM currency weakness is the flipside of US dollar strength. As the long dollar rally fades, EM currencies must, by necessity, perk up. Likewise equities: with the S&P 500 breaking record highs for so long, regardless of the US economy’s reluctance to really ignite, some investors may have decided to spread some risk into EMs.
But other changes have taken place. One predates the EM recovery by 15 months, to November 2014. That is when the weight of technology stocks in the benchmark MSCI EM equities index overtook the weight of energy and materials — the commodities stocks that many see as emblematic of emerging markets.
This transformation has been dramatic. When the commodities supercycle was in full swing, in mid 2008, energy and materials accounted for more than a third of MSCI EM market capitalisation and tech companies just a tenth. Last month, the commodities group was barely an eighth of EM market cap, and tech companies more than a quarter.
This should be no surprise. EM tech companies include the Chinese internet trio of Tencent, Alibaba and Baidu and longer-established names such as Hon Hai and TSMC of Taiwan and Samsung Electronics of South Korea. Stocks from those three countries have delivered more than 70 per cent of the gains in the MSCI EM index this year.
At the other extreme, commodities companies have been slammed by falling prices, not to mention the corruption scandal that has engulfed Petrobras, the Brazilian oil company that together with miner Vale once carried half the São Paulo Bovespa index on its back.
Accompanying the rise of EM tech has been the enduring strength of consumer discretionary and financials, which together make up more than a third of MSCI EM.
Put it all together, and the asset class looks more like a play on the manufacturing and consumer dynamism currently making Asia the world’s fastest growing region than on the commodities demand from China that drove EM growth in the first dozen years of this century.
But not so fast. First of all, Asia’s dynamics may not last. While trade within the region has grown strongly, its exports also depend on demand from the US and Europe. While the US consumer is expected to spring to life with every passing day, she has so far failed to do so.
More broadly, global trade has disappointed. Data from the CPB World Trade Monitor, a widely-respected unit within the Dutch ministry of economic affairs, show a surge in global trade between May 2016 and January this year — strongly positive news for EMs. But the momentum of trade growth has faded this year and the latest CPB data, out last week, show it falling back towards zero.
Nor are EMs free of the commodity curse. Even today, energy and materials companies play a far bigger role in the MSCI EM index than the direct contribution they make to their home countries’ economies. But they also have a powerful multiplier effect on other business sectors.
Adam Slater, chief economist at Oxford Economics, points out that, in the past, falling commodity prices would have been net positive for global growth: the losses suffered in commodity exporting countries would be more than offset by rising consumption and investment in commodity importers.
This time, that hasn’t happened. It may be that commodity prices have fallen too far from their peaks and that a host of investments have lost their viability. Consumption seems to have been curtailed by fear of the future in a low interest rate world.
This does not mean the EM rally will end now. EM assets were severely hammered during 2014 and 2015, by the commodities crash and by fear of a hard landing in China. Now, the EM/DM growth differential has reverted to the mean and EMs are again outperforming. But investors should still beware the signs of froth.