The Long Period of Underperformance for Emerging Market Stocks May Finally Be Over

The end of the long period of emerging market stocks’ underperformance is supported by a recent change in trend for each of the four drivers of emerging markets.

Key Points

  • The end of the long period of emerging market stocks’ underperformance is supported by a recent change in trend for each of the four drivers of emerging markets.
  • The relative stock market performance of emerging market countries is impacted by four drivers: global & domestic economic growth, currency movements and commodity prices.
  • The longer-term trend appears favorable for emerging market stocks, but risks to these drivers—including a rebound in the dollar—may negatively impact the relative performance of emerging market stocks.

Shifts in four major performance drivers suggest that the longer-term downtrend in emerging market stocks’ relative performance to developed markets has come to an end.

A simple way to see how the trend in emerging market performance (relative to developed market stocks) has changed is to compare it to the last performance cycle, going back to the inception of the MSCI Emerging Markets Index in 1988. From 1988 through 2003 and again from 2004 through now, there was first a long period of strong outperformance followed by a long period of sharp underperformance, then a less dramatic trend that favored emerging market stocks on balance, as you can see in the chart below. We may have entered this later stage of the emerging market relative performance cycle, marking an end to the long period of underperformance.

The end of the long period of underperformance for emerging market stocks

The end of the long period of underperformance for emerging market stocks

Emerging Market stocks = MSCI Emerging Market Index, Developed Market stocks = MSCI World Index
Source: Charles Schwab, Bloomberg data as of 5/26/2017.

We believe the cycle has repeated itself and the long period of emerging market underperformance has likely come to an end, because of a change in the key drivers of relative performance. Unlike developed market stocks, which are more driven by the sectors that dominate them (for more insights on drivers of developed country stock markets see: Your Portfolio May Be Less Diversified Than You Think), each emerging country’s stock market has a different sensitivity to each of the four primary drivers displayed in the graphic below (for more insight on these drivers see: Different Drivers: Why Emerging Market Stocks Aren’t All the Same).

Emerging market countries have differing sensitivities to performance drivers

Emerging market countries have differing sensitivities to performance drivers

 

The trend in each of these four drivers of emerging market relative performance appears to have recently changed. Let’s take a look at each of them.

Developed Markets

One of the most powerful drivers is the growth of developed market economies, stimulating demand for emerging market products. The International Monetary Fund forecasts global nominal GDP to be above 5% in 2017, the strongest growth rate since 2011, marking an end to years of weak developed country economic growth that contributed to emerging market underperformance.

Global growth acceleration in 2017

Global growth acceleration in 2017

Source: Charles Schwab, Bloomberg data as of 5/26/2017.

Domestic economy

Some emerging market countries are more driven by growth within their borders. While India’s economic growth has remained stable at around 7%, China’s much larger economy has seen a slowdown. China’s growth rate has declined nearly in half since early 2010, slowing sharply from 12% to 7%. Now, China’s maturing economic growth has shifted to a more modest pace of slowing, as you can see in the chart below. A more stable growth rate for China may have less of a negative on emerging market stock market performance.

China’s economic growth has become more stable after falling sharply

China’s economic growth has become more stable after falling sharply

Source: Charles Schwab, Bloomberg data as of 5/26/2017.

Currency markets

Some emerging market country stock markets are very sensitive to moves in global currency markets, specifically the U.S. dollar. A rise in the dollar can mean more costly debt for emerging market countries with dollar-denominated debt. It can also suggest that investors are moving their money to safe havens, like the United States, and withdrawing it from emerging markets, leaving behind deteriorating financial conditions. The U.S. dollar has been rising since 2011, acting as a drag on emerging market stock performance. Recently, that trend has eased and even reversed to some degree. This change in trend has helped boost the relative performance of stock markets in some emerging market countries. However, this change may only be a temporary pause, as rising interest rates in the U.S. pose the risk of a return to a rising trend in the dollar versus emerging market currencies.

The dollar has paused in its climb against a broad number of currencies

The dollar has paused in its climb against a broad number of currencies

Source: Charles Schwab, Bloomberg data as of 5/26/2017.

Commodity markets

While most emerging market countries are net importers of commodities, some are net exporters and are therefore sensitive to trends in commodity prices. After falling for much of 2011 through 2015, the prices of raw materials have partially rebounded in the past year and a half, as you can see in the chart below. This rebound has helped the relative stock market performance of some emerging market countries.

Commodity prices have partially rebounded over the past year

Commodity prices have partially rebounded over the past year

Source: Charles Schwab, Bloomberg data as of 5/26/2017.

Risks to the emerging trend

The end of the long period of emerging market stocks’ underperformance is supported by the trends in the four drivers of emerging markets entering a new phase. However, there are risks to these trends. Especially concerning is the potential for the U.S. dollar to stabilize or rebound as the Fed continues to hike interest rates, taking away one of the four drivers. Additionally, a slowdown in China and related decline in commodity prices also poses risks, but likely only temporary ones as policymakers would likely take action to return the economy to a more stable growth trajectory around 6.5%.

A diversified asset allocation that includes emerging market stocks has felt the impact as they underperformed developed markets in recent years. Despite the risks, emerging market stocks may benefit portfolios in the years ahead if the trends in these underlying drivers continue to unfold.

 

Next Steps

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Important Disclosures