The recovery in emerging market equities: is it all commodities?

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After years of underperformance, emerging markets have managed to outpace their developed market peers so far this year.

Through 6 May 2015, the MSCI Emerging Markets was up nearly 3% more than MSCI’s The World index (in local currency terms). There is a worry among investors, however, that this outperformance is driven primarily by the recovery in commodity prices, and if prices decline again that emerging markets equities would follow suit.

The first question to ask is whether emerging markets are really as dependent on commodities as many perceive. It turns out not to be the case. If one considers merchandise exports, commodities account for the same share (25%) for emerging markets as they do for developed markets (taking only those emerging market countries in the MSCI EM index and using export data from The World Bank for 2014). Manufactures make up the rest.

Nor are emerging market equities much more exposed to commodity sectors than developed markets. The energy and materials sectors have a slightly higher weight in the MSCI Emerging Markets index than in the MSCI The World index (14.8% vs 11.4%), but this is far less than the overweight of financials (7.4%), or the underweight in health care (-10.3%, see exhibit 1).

Exhibit 1: Relative sector weights, emerging versus developed market equities

relative sector weights

Source: MSCI, BNP Paribas Asset Management. Data as of 6 May 2016.

There could be indirect exposure to commodities through the relatively larger financial sector to the degree that emerging market banks have a higher share of loans to companies in the energy and materials sectors than do banks in developed markets. This is likely the case for, say, China. Hence one would expect emerging market equities to show a modestly higher sensitivity to commodity prices changes, all things equal.

In the emerging markets rally this year, emerging market commodity sectors have indeed outperformed the corresponding developed market sectors by 3.3%, but non-commodity sectors have also outperformed, if not by as much, just 1.4%. Despite the reasonably high correlation between the outperformance of the emerging market equities and commodity prices (59% year-to-date), emerging markets have underperformed since the beginning of April even as commodity prices have rallied strongly (see exhibit 2).

Exhibit 2: Emerging market sector relative returns and commodities

em sector relative returns

Source: MSCI, BNP Paribas Asset Management. Data as of 6 May 2016. Note: Total return in local currency, MSCI Emerging Markets index relative to MSCI The World index.

The recovery in commodity prices has helped the energy and materials sectors in both developed and emerging markets outperform other sectors in the market, but all sectors are well above levels from mid-February. The question is what could drive further emerging market equity outperformance from here. Valuations, as we discussed in a recent article (see Weekly Intelligence Report from 5 April 2016, “Are emerging market equities cheap?”), are comparatively better for emerging markets relative to developed markets, though much of this discount is concentrated in China and in financials, where arguably low valuations are warranted. The longer-term earnings growth outlook for emerging markets is good as margins are still well below average. In the short-term, any indication by the Fed that it will be hiking rates sooner rather than later will likely weigh again on the relative performance of emerging market equities and currencies. But it is more encouraging, and more important, that the gap in relative profitability of emerging market corporates is starting to narrow, and not just in commodities sectors.

Despite the recent underperformance of emerging market equities, all sectors have done better than their developed market counterparts this year, so the recovery in emerging markets is not just down to commodities. Valuations are comparatively appealing, and profitability is rising for many sectors. Interest rate hikes in the US or a shock from China could derail the recovery, but over the course of the year, we would expect to see emerging market equities sustain their outperformance.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.

Daniel Morris

Senior investment strategist, CFA charterholder

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