Most EM equity markets are trading well below their January highs, which suggests recovery potential, but we believe that now is not the time to increase exposures. Our reasons do not reflect a strong conviction that EM markets are about to turn down. Rather, our judgment is that currently, uncertainties about the geopolitical risks and economic outlooks for EMs are unusually high. Positive news about EM economic recoveries or an effective Covid vaccine would push valuations higher, but strong second-wave virus outbreaks could easily undermine the hoped-for recovery, while US election chaos and heightened global geopolitical risks might harm EM risk sentiment. Looking at rising equity volatilities, we conclude that markets are not ignoring such downside risks; the point is that right now, the upside potential and downside risks for EMs are to a large extent unknowable. We think that in this situation, it makes sense for investors to step back and wait out the market volatility over the coming weeks.
Among EMs, China has been the star performer in the equity space by a large margin. As Chart 1 highlights, the performance of China’s MSCI Equity Index in dollar terms far outstrips comparable indices for other EMs. India is China’s closest competitor, but its MSCI Index is down 8.4% from its January high vs China’s 6.4% rise. All the other EMs that we follow are down more than 20% vs January highs, ranging from a decline of 22% in Philippines to a fall of 44% in Brazil.
The outperformance of Chinese equities outside the EM world is noteworthy, too. As Chart 2 shows, the two major MSCI Indices for Chinese equities have turned in strong performances ytd vs the corresponding MSCI US Index. Despite declines in September, the A-share index is up 18.5% and the broad index, which is dominated by Hong Kong H-share listings and several Nasdaq stocks, is up 12.1%; by comparison, the US MSCI equity index is up 5.4%ytd (3dma in dollar terms for all indices). While the performance of Chinese shares trails the 25% rise in the NASDAQ ytd, it is far ahead of both the Dow and S&P.
There is no mystery to the secret of China’s success: it comes down to effective control of the virus and the right mix of fiscal stimulus and monetary caution. China has successfully brought the pandemic under control, as have South Korea and Taiwan (which we do not include among our EM countries). The combination of strong fiscal stimulus and cautious monetary policies has put the economy on track to sustained economic recovery. Among the other nine EMs that we follow closely, only Thailand has succeeded in conquering the pandemic – the number of daily confirmed cases averages below 10 – but the country is still far from getting the economy on track to sustained recovery, largely because of the significant economic role played by tourism, which has not yet begun to recover. Several EMs have seen a peak in the number of daily confirmed virus cases, but the number remains sizeable: India, 80,000, Brazil 30,000, Mexico 4,500 and the Philippines 3,000. Three countries, meanwhile, are experiencing a second rise: Russia 8,000, Indonesia 4,000 and Turkey 1,500. The last EM in our coverage, South Africa, is an outlier: while it has brought the number of daily confirmed cases down to 900 from a peak of 14,000 in mid-July, it is far from economic recovery with GDP projected to fall 10% this year.
We conclude that a return to sustainable economic growth in most EMs remains a far-off prospect. EM policymakers are loath to reimpose broad lockdowns, which means that in the absence of a vaccine, the pandemic will continue to spread to a greater or lesser extent and, accordingly, there will be a greater or lesser impact on economic activity. Assuming, optimistically, that the impact of the pandemic is reduced either by a vaccine or by the prevalence of less lethal strains of the virus, EM policymakers will face a major challenge to get economic policy right. It will prove tricky to finance expanded fiscal deficits without triggering inflation. However, the lesson from China’s economic recovery is that more fiscal spending is an essential component of a viable recovery strategy. The worst approach would be to adopt the soft option of relying on increased central bank financing of budget deficits but then fail to redirect government outlays into actual spending on projects. Such a policy mix would sooner or later fuel inflation and the flight of foreign portfolio capital.