When the German Marxist philosopher Theodor W. Adorno famously stated that there is no true life within a false life, he probably was not referring to emerging market equities. Still, his dictum comes to mind, when looking at the recent rally in emerging market indices.
Since it hit the bottom in January, the MSCI Emerging Markets index gained 15% in dollar terms (from Jan 21 to mid-March) and outperformed its developed markets equivalent by 7%. This has taken place at a time when growth forecasts both for emerging and developed markets have been further slashed, the economic newsflow out of China deteriorated, and the US Federal Reserve kicked-off the process toward a normalization of US interest rates. Thus – paraphrasing Adorno – the question is whether emerging markets can enjoy a bullish life, while the rest of the world is living a bearish life.
The recent history is not encouraging. Since 2011, when emerging market stocks peaked in US dollar terms, we had more than half a dozen rebounds of emerging markets, some of them lasting more than four months or longer (Figure 1). However, all stronger rallies happened before 2015, when global equities were still on an upward trend. In 2015, against a backdrop of frail global markets, a deteriorating growth outlook and the Fed’s anticipated tightening, rallies become shorter and more timid. The last rally before the current one lasted less than two months and lifted the MSCI Emerging Market index by just 12%.
Rally enjoying support – for now
That said, the ongoing recovery might still have some way to go. While the global backdrop remains fragile, a number of developments will likely support the current ‘risk-on’-regime (which, in financial market lingo, describes a situation where investors are prepared to take on more risk).
Most importantly, commodities seem to have found a bottom. In particular, crude oil – which in January was trading below $27 per barrel, a level last seen in 2003 – posted a strong rebound. The fact that the collapse of crude prices apparently was among the key factors driving share prices down at the beginning of the year is still a bit of puzzle given the huge gain for oil-importing countries. But whatever the transmission channels may be, oil’s bounce has supported equity markets both in the developed and in the emerging world. Also industrial metals, after falling in January to the lowest level (measured by the S&P Industrial Metals Index) since the second quarter of 2009, have rebounded.
Equally important, the Chinese government seems to be determined to prevent their economy slowing too fast. Of course, there is no guarantee for success. Evolving cracks in the financial system as well as policy limitations related to the “impossible trinity” – the impossibility to set independently monetary policy and currency targets, while maintaining a liberal regime on external capital flows – make it harder to support economic growth. However, at least for now, China’s government managed to defuse the fears about a major financial crisis and economic collapse that ruled the markets in January.
Finally, the world’s major central banks continue to support markets. In early March, the European Central Bank doubled down on its attempt to get credit growth going in Europe. In addition, in the US, the Fed appears to have turned more dovish than it was a couple of months ago. Four rate hikes in the course of 2016, as guided in December, seem rather implausible, and are definitely not in line with what the market expects.
While these near-term tailwinds for risky assets – including but not restricted to emerging market stocks – could fuel the current rally for some more time, the longer-term outlook remains challenging. Most importantly, global growth is still pedestrian, with revisions pointing downward (Figure 2), and without any obvious catalyst that could trigger a turnaround. Japan is flirting with recession, US growth is expected to slow versus 2015, and the growth in the Eurozone – while above potential – is struggling to exceed 1.5%.
In addition, the state of the Chinese economy – despite the government’s efforts mentioned above – remains a concern. A further significant drain in reserves could lead to a further weakening of the Chinese currency, which would entail unpleasant spillovers both for emerging economies and subsequently for the developed world by increasing deflationary pressures. Last but not least, in Europe during the run-up to the British EU referendum in June, volatility (which only recently has returned to more comfortable levels with the VIX, a volatility index, falling from 27 in mid-February to below 17 in March) is set to climb again.
Bottom line: Enjoy the current rally in EM stocks for as long as it lasts, but remember Adorno – there is no true life for emerging markets in a false world.