Here’s why the region tipped for 2021 has not delivered so far

Tom Bailey explains why emerging markets have not been buoyed by the improving economic outlook. 

With vaccines being rolled out and the end of the pandemic potentially in sight, it has mostly been a good year for equity markets so far.

As of 21 May, the MSCI All-Country World Index has returned 5.5% (sterling terms, as all subsequent returns will be) while the FTSE World index has returned 6.3%. Meanwhile, the FTSE 100 has returned 10.4%, the MSCI AC Europe index 8.1%, and the S&P 500 7.4%.

However, there is one big part of global equity markets that has mostly proven disappointing so far this year: emerging markets. The MSCI Emerging Markets index has lost almost 1%, while the FTSE Emerging index has lost around 0.5%.

Emerging markets were heavily tipped to perform well in 2021. In Bank of America Merrill Lynch’s Global Fund Manager Survey for December, 60% of those surveyed said emerging markets would be the best performer of 2021. In addition, investment trust fund managers were most positive on the outlook for emerging markets compared to other regions heading into 2021.

Why are emerging markets faring so poorly? Surely the improved global economic outlook should be lifting all boats, in a globalised and interconnected world?

One broad explanation is that emerging markets have continued to be more affected by the virus this year. Less wealthy countries have not had the same access to vaccines, meaning the time frame for getting back to normal economic life is likely going to take much longer than in Europe and North America.

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This may explain some of the poor performance of emerging markets this year. However, there are a few problems with this explanation.

With India accounting for almost 10% of the MSCI Emerging Market Index, the country seems a likely candidate for contributing to the index’s weakness, due to the severity of its Covid-19 outbreak this year. But despite the human toll the virus is having there, equity markets are showing positive performance. The MSCI India Index has a year-to-date return of 4.3% and the FTSE India index 6.4%. India, therefore, has been able to outperform the emerging market index.

On the other hand Brazil, which accounts for 4.6% of the index, has fared badly, returning -2.13% so far this year. Brazil’s lacklustre performance is also being put down by some people to new Covid-19 outbreaks and a weak government response. However, its poor performance occurs alongside a severely depreciated currency, suggesting that perceived political risk in the country is playing a role.

There has also been some idiosyncratic political risk in other emerging markets. Most notably, Turkey saw a major devaluation of its currency and fall in its stock market following the firing of yet another central bank manager. Turkey, however, comprises a relatively small part of the index.

China or tech to blame?

Instead, China may have the most to do with the underperformance of emerging markets. China now accounts for around 40% of the MSCI Emerging Market Index. And since the start of the year, the MSCI China index has lost almost 4.5%.

China’s subdued performance, combined with its monster weighting, goes a long way in explaining the poor performance of the overall emerging market index.

However, there is another way to look at it. Instead of considering countries, we can look at the sector and style weighting of the emerging market index.

Over the past decade, the emerging market index has become increasingly technology-company focused. So, for example, according to Renaissance Capital, almost 40% of the emerging market index can be classified as technology-related companies. That is eight times larger than the index’s weighting towards energy and four times larger than the weighting towards materials.

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Materials and energy are the sort of sectors you would expect to perform well in the face of global economic growth. In contrast, many technology-related stocks around the world have struggled this year globally, with investors shunning growth stocks in favour of value and cyclical stocks. Technology stocks, of course, are largely growth stocks, and energy and materials are more likely to be part of the value and cyclical camp. Seen like this, the emerging market index has been a victim of the market rotation from growth to value.

We can also see this in the performance of MSCI Emerging Market sector sub-indices. So, for example, the MSCI Emerging Markets/Consumer Services Index has lost over 16% year to date, while the Consumer Discretionary Index has lost 9.6%. Many of the online platforms and e-commerce stocks seen as technology companies are found in these sectors, such as Alibaba (LSE: NYSE: BABA), Meituan (SEHK:3690), JD.com (NASDAQ: JD) and Pinduoduo (NASDAQ: PDD).

The MSCI Emerging Market Information Technology sub-index has fared slightly better than these sectors, albeit still with a loss of 1.2%. This sector was likely buoyed by the strong performance of tech hardware exporters, often in the semiconductor space. Taken together, these three sectors, all sitting on losses, account for almost half of the emerging market index. 

Another way to measure this is to look at the performance of the HAN EMQQ Emerging Markets Internet & Ecommerce ETF (LSE: EMQQ). This fund tracks a basket of e-commerce and online shopping-related stocks in emerging markets. Year-to-date, it has lost 8.7%, significantly more than the broader emerging market index.

All this goes to show that emerging markets are a very different animal than they were a decade ago. In the past, it might have been expected that emerging markets would perform well in an era of increasingly bullish global economic outlook, with commodity prices rising.

For investors looking for that sort of emerging market exposure, the broad emerging market index, and the funds that track it, may not be the best option.