Starting the year with high hopes, emerging markets instead fell flat on their face, suffering a 7 per cent drop in sterling terms since 1 January.
By April the MSCI Emerging Markets index had regained its first quarter losses. Diverging from developed markets in July, EM outstripped the MSCI World index by almost 5 percentage points at its peak in early September.
In the past month, however, the 14.2 per cent peak year-to-date return has sunk 9.1 percentage points, leaving its annual record at a more modest 3.8 per cent.
In comparison, the S&P 500 has returned 8.8 per cent in the calendar year to 1 October while the FTSE All Share returned just 38 basis points over the same period.
The EM plummet early this year was sparked by the US Federal Reserve’s move to taper its bond and asset-backed security purchases.
JP Morgan Asset Management global market strategist Kerry Craig says the correction was driven by uncertainty about China’s growth, which has been declining lately, as well as political trades in Brazil.
Moves in Brazil, China and Korea have a large influence on the MSCI Emerging Markets index, he adds.
The Brazilian Marina Silva trade has been unwound in dramatic fashion, with the market falling off a cliff last month, wiping off 20 per cent of its market cap peak to trough in sterling terms.
The hope of an electoral win by business-friendly Silva, at the time of writing, had been soured by incumbent Dilma Rousseff’s lead in the polls.
China is down 9.9 per cent in sterling terms since its peak early last month as the latest manufacturing figures disappoint once more.
Smaller emerging markets have been dragged into the sell-off, Craig adds, although their falls have been relatively muted in comparison.
Investors need to divide the emerging markets by their economic bias and their fiscal and monetary positions rather than lumping them into “one homogenous blob”, he says.
With weak global demand keeping commodity prices depressed, manufacturing countries that are importing raw materials are a much more attractive proposition than those doing the selling.
“Given that most emerging markets are yet to see a pick-up in corporate earnings, it seems likely that the change in investor sentiment has been driven by the attractive valuation of the emerging assets relative to developed markets,” Craig says.
As the season of emerging market elections begins to wind up, some countries have found themselves with better leaders and the rest have greater certainty, he adds.
The August Bank of America Merrill Lynch fund manager survey shows investors’ intention to overweight the long unloved asset class hit an 18-month high.
That is evidence of the improving sentiment following the brutal sell-off in May last year when the index fell almost 14 per cent, Craig says.
“We always say they offer potential and offer return but they are notoriously volatile.
“That’s why emerging markets are a long-term proposition; you need that time to beat volatility.”
Ashmore head of research Jan Dehn says the falls enveloping emerging markets have “nothing to do” with their fundamentals and everything to do with investors’ nervousness about the recovery of the developed world.
Just like the sell-off in May last year, when markets priced in aggressive monetary tightening from the US after the Fed’s announcement of tapering, emerging markets are
being battered by curdling optimism in the West, he explains.
Dehn believes the Fed economists’ more aggressive interest rate hike prediction, released last week, has spooked the markets.
The outlook for inflation has fallen because of a weakening view on the country’s growth, to the point where five-year treasuries are offering a positive real yield, he adds.
Investors have started to buy up dollars, causing an 8.8 per cent appreciation against a basket of developed market currencies.
Since May, EM currencies have fallen 6.7 per cent compared with the dollar while the euro has weakened 10.6 per cent, Dehn says.
Rather than investors getting bullish about the US story, it is a bear trade, he argues. “This is the market getting very scared of recession that would be triggered by a policy mistake by the Fed.”
Dehn expects the Fed to move interest rates more slowly, which should see the effects of the past few weeks unwind. While a strong dollar is traditionally bad news for developing markets, it will not bode well for the US either, he says.
“A 10 per cent move in the dollar has usually wiped out between 0.5 and 1 per cent of US growth. Given that growth is roughly 2 per cent per year, that is definitely not a situation in which you want to start raising interest rates.”
Meanwhile, most emerging markets have put their finances in order and have reasonable growth forecasts and rock-steady bond yields, he adds. “They will be fine through this, they don’t mind a bit of currency weakness increasing their competitiveness.”
One potential cause of further trouble is the stand-off between protestors and the Hong Kong state over electoral freedom.
A protracted repression is likely to have monumental implications for China, as well as for all the countries depending on its growth, according to Capital Economics chief markets economist John Higgins.
Hong Kong has long been a conduit to the global markets and a money earner for the mainland, he explains.
“If Hong Kong’s status as an international financial centre were jeopardised by such a nasty turn of events – as it presumably would be – then China’s own economy would suffer.”
Higgins adds while troubles in Ukraine, Syria, Thailand and Iraq have barely registered with global investment markets, Hong Kong’s connectivity may make it a different story.