November’s Market Voice analyzes the state of equities in emerging markets as they recover from the impact of COVID-19. Why have some markets — in particular those in Asia — rebounded, while others, such as Russia and Turkey, lagged?
- In spite of the economic turmoil of COVID-19, equities in some emerging markets have rebounded to levels seen before the pandemic.
- However, the performance of equity markets varies across the emerging markets landscape, with Asian markets recovering more quickly than Russia and Turkey, for example.
- By taking interest rates towards zero, a number of emerging market central banks have helped to enable their economies to function close to normality.
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COVID-19 continues to constrain economic activity across the globe and there is no solution on the immediate horizon. Nevertheless, U.S. and global equity markets have recovered.
The SPX is almost 4 percent above the pre-COVID high despite U.S. economic activity and employment still well below pre-COVID levels. The SPX gains have been broadly mirrored in national indices across the globe, but the gains have been particularly strong in the emerging markets.
Emerging markets equities are outperforming
As shown in Figure 1, EEM (MSCI Emerging Market ETF) has recently surged vs the SPX to trade near all-time highs and EEM significantly outperformed the broader VEA (Vanguard Developed Country ETF).
The message is that emerging market equities are outperforming the general developed markets — even including U.S. equities.
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Copper prices are also overlaid in Figure 1 as a real-time proxy for global economic activity.
A general improvement in global economic conditions is reflected in copper trading at roughly 10 percent above the pre-COVID high. But copper does not seem to tell the entire story since EEM was relatively soft during the summer months despite a steady uptrend in copper prices.
And there is also a classic chicken/egg conundrum: Is the EEM strength reflective of higher copper prices or is stronger activity in EM economies propelling both copper prices and equity prices higher?
Figure 1: Emerging market relative performance and copper prices
Emerging markets are a performance patchwork
Figure 2 shows comparisons of how the five-month old global market recovery is reflected in different major national markets (converted to USD).
Consistent with Figure 1, EEM has generated almost double the performance of the VEA during this period, but there has been substantial variation in returns across individual markets.
Within the developed markets, Japan has paralleled the U.S. gains but Europe, and (perhaps reflexing the looming Brexit) especially the UK, have badly lagged.
The variation within the EM markets is even more extreme: The Asian emerging markets are the global star performers, whereas LATAM markets are more mixed and EMEA (Emerging Europe, Middle East and Africa), except South Africa, has fared poorly.
It is notable that the commodity-oriented Chilean and Russian markets have lagged, suggesting that emerging market performance is driving copper prices higher rather than the reverse.
If higher commodity prices are not the source of EM strength where is it coming from?
Figure 2: USD denominated equity performance since 31 May
What are the sources of emerging market growth?
Figure 3 suggests that part of the equity story reflects relative success at controlling the spread of COVID-19.
As is shown, new cases in the major East Asian markets (including Japan) are close to zero, suggesting that COVID-19 is under control (for now), which has allowed economic activity to normalize.
While the leading performance of the Asian markets can, in part, be attributed to the fading of COVID-19, this is clearly not the whole story.
The U.S. market has been relatively strong despite one of the highest COVID-19 case rates in the world and while the LATAM markets have shown more mixed performance, it seems strong relative to the COVID-19 case rates.
Figure 3: New daily COVID-19 cases (end-October per 100 million of population)
The advantage of high rates
A concern regarding near-zero (or negative) interest rates by the Fed and other developed-country central banks is that it leaves little latitude to provide ease in the event of an economic crisis.
This has proved true in the wake of the March COVID-triggered market swoon.
With little room to cut rates, the Fed has resorted to unprecedented means of injecting liquidity into the market, including buying municipal and high-quality corporate bonds.
While rates in the emerging markets have trended lower in recent years, most rates remained well above zero at the beginning of 2020. Consequently, there has been more room to provide traditional support to financial markets via lower rates.
As shown in Figure 4, rates are only marginally lower in the developed countries, and the impact in Europe and Japan is moot as they are already in negative territory.
While there has been high variation across emerging markets, several countries were in a position to provide substantial ease via lowering — still positive — interest rates. Rate cuts seem to be a significant source of support in India, Indonesia, Brazil and to a lesser degree in Mexico and Chile.
Gains in the Brazilian and, especially, Chilean market have been limited by the relatively high contagion rate seen in Figure 3. Notably, exchange rates in these countries appreciated despite the lower rates giving a two-barreled boost to equity prices — easier credit conditions and a translation gain into USD.
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While Chinese equity prices did get a valuation boost via a stronger CNY, rates were an outlier to the topside. But this reflects that China was both extremely aggressive in its early response to the virus and is now seeing the benefits of this with almost no reported new cases and near-full resumption of normal economic activity.
The higher rates are a positive sign of economic health. The same cannot be said for the Turkish markets, where rates soared 650 basis points while the TRY plunged 20 percent, reflecting irresponsible monetary and fiscal policy dating back to the middle of 2019.
While the picture in Russia is less dire, the rate cuts here were accompanied by RUB weakness, reflecting that inflation has been trending higher since the middle of last year and is now near 4 percent.
The Turkish and Russian markets have been the two worst performers since May, but clearly this is due at least as much to negative economic domestic fundamentals that pre-dated the emergence of COVID-19.
Figure 4: Basis point change in 3M deposit rate against currency appreciation vs USD since 1 June
Emerging market rates approach zero
While COVID-19 continues to hamper social and economic activity, it does appear that some markets have managed to contain the pace of contagion enough to allow near-normalization of economic activity.
The leader is East Asian countries where in recent weeks there have been few new cases reported. Many emerging economies have also benefited by their central banks now following the lead of the developed world in taking rates towards zero.
While a few countries — Turkey and Russia — saw their currencies pummeled as rates declined, most emerging market currencies have strengthened in recent months, reflecting improving economies.
With rates in the emerging world now approaching zero, as in the developed world, lower rates are being eliminated as a policy response to economic weakness.
The emerging market central banks now have little latitude to respond to a COVID-19 resurgence, so it will be critical to monitor the pace of contagion in these countries in the months ahead.
Eikon subscribers can track this information in real time, as well as the broader impact of the virus on economic activity and market pricing by typing ‘COVID’ in the Eikon browser.
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