Maarten-Jan Bakkum, Senior Strategist, Emerging Markets at NN Investment Partners
So far it has been an excellent year for emerging markets (EM). Growth is accelerating in most countries, inflation is at the lowest level on record, interest rates are declining and their equities are evidently outpacing those of developed markets (DM). The outperformance of EM versus DM equities amounts to more than 10 percentage points so far this year. Much of this success is attributable to two factors: the perception of lower systemic risk in China and the persistently low interest rates in the US and Europe.
In previous years, China posed the biggest challenges to emerging markets: an accelerating growth slowdown coupled with capital flight and a rapidly rising debt ratio. In 2015 and early 2016, the fear of a potential systemic crisis in China reached such high levels that it affected financial markets globally. Emerging markets, in particular, were hit hard by capital outflows and sharp currency devaluations. Since then, Beijing authorities have managed to alleviate the biggest worries. China introduced extensive capital controls to restrict capital outflows, while targeted stimulus measures have tackled the slowdown in its economic growth. Especially the improving housing market has played an important role in restoring confidence. Since the end of 2016, tighter regulation for shadow banks, which are responsible for most of the credit growth of recent years, has certainly helped as well.
Overall, the perception of investors towards the Chinese systemic risk has improved significantly. This is clearly reflected in the Chinese CDS (credit default swaps) spreads, which have fallen sharply since February 2016 and are back at the low pre-2014 levels. Nevertheless, there are still many questions about the sustainability of the credit-driven Chinese growth model. But let’s not go there right now. As long as the Chinese risk is still being priced out, emerging markets will have a good run.
There is another factor that has helped the recent recovery of emerging markets: the persistently loose monetary policy stance in the US and Europe. Over the course of this year, market expectations of policy tightening have been gradually pushed further into the future. This means that interest rates in the US and Europe are barely, if at all, increasing, and investors are still willing to seek returns in emerging markets. The result: strong capital inflows, appreciating currencies and falling interest rates. This effect is reflected in higher credit growth and a rapid increase in both consumption and investment spending. The latest inflation figures in the US and Europe and the tone of the Fed’s and the ECB’s statements do not seem to indicate that this favorable environment for emerging markets is about to change.
Given the perception in the market that the Chinese economy can maintain its high growth rate and with little reason to worry about interest rates in developed markets, emerging markets keep on enjoying a tailwind.