EM VERSUS DM REVISITED; THE IMPACT OF ‘REVERSE CONVERGENCE’

So, to be clear at the outset I don't believe that there is any reason for EM equities to be treated as a discreet asset class other than to give skilled investment managers a more concentrated opportunity set, as outlined in my note 'Emerging Markets, the Myth that Failed'.

However, many investors do still allocate to emerging markets, so in this note I'll address the outlook for EM equities against developed markets, specifically the US, which is no longer anything like as attractive as was the case in 2010 (I say this not with the benefit of hindsight but having consistently advocated overweighting of US index funds versus all other assets as a sell-side strategist).

There are three scenarios in which EM equities could outperform their developed market peers over the medium and long term.

• Scenario one would be a renewed emphasis on structural reforms for the first time since the wake of the EM crises in the late 1990s/early 2000s, these reforms having been one of the major drivers behind the Great Emerging Equity Bull Market of 2002-2008. Given the increasingly obvious problems facing the state-driven Chinese model, there are indications that some governments are beginning to turn back to more market-driven reforms, namely South Africa, Argentina and Saudi Arabia, whilst India has been a consistent but slow reformer. However, even in these countries progress is patchy and there are some conspicuous recidivists elsewhere, most notably Mexico.

• Scenario two is the potential re-liquification and/or the rebalancing of the Chinese economy and shift towards consumption (stop me if you've heard that one before) and more productive investments. It's too early to tell if the ongoing stimulus efforts represent anything more than a band aid but it's difficult to envisage any government led by Xi Jinping executing a wholesale volte face by shifting the emphasis away from state domination towards a much bigger role for market forces.

• The third scenario and the most widely cited positive factor for EM debt and equity now, is the perceived relative macro-economic stability of leading EMs against their DM peers or what I term 'reverse convergence', that is developed markets converging towards their emerging peers so effectively a direct reversal of the prevailing orthodoxy before the GFC. The sentiment behind this concept was nicely summed up by a comment after an article on inflation in the FT (16th October):

As others have noted, the US should now be in the EM bucket. Trumpism/populism, institutional decay, fiscal recklessness, government capture, bubbles, extreme inequality — the US is far more like Brazil than Germany or Japan.

Unfortunately, this is by far the most convincing of the three scenarios.

Concerns across the most prominent developed economies focus on the rising levels of government debt because of rising inequality, demographic shifts and most recently increasing geopolitical tensions pushing up defence expenditure, with the base figure blown up by the (over) reaction to the pandemic.

The debt dynamics across the most prominent emerging economies have not deteriorated at anything like a comparable rate with the partial exception of China, where consolidated government debt is running at a comparable level to the US, when contingent liabilities are included. This has helped USD denominated emerging market debt to outperform developed market sovereign debt over the past twelve months after several years of moving closely in line.

However, the strength of the US currency has damped down USD denominated overall returns on EM local currency debt, even though yields on China renminbi debt which is now the single biggest index constituent, have moved sharply lower as the economic backdrop has become more deflationary.

Will the generally improving perceptions of macroeconomic stability across much of the EM universe relative to many of the most prominent developed economies eventually translate to equity outperformance?

From an EM perspective macroeconomic stability does not always feed through to the more micro level which is critical for equity markets. Sovereign and corporate governance is where the macro meets the micro and here developed markets and in particular the US retain an advantage over most of their emerging market peers, for the time being at least. The big threat on a more micro level is the potential for increasing government intervention, especially through tighter regulatory oversight of the technology sector, although the limited measures enacted so far most notably in Europe, have had relatively little impact on share prices.

We should also note that the creation of a more resilient and crisis proof framework means almost by definition that a particular country becomes less dependent on external finance and therefore less amenable and accountable to external pressure. In the case of Russia, this was leading to a more autarkic governance regime or 'fortress Russia' long before the invasion of Ukraine in February 2022, with the subsequent imposition of sanctions by the US and her allies leading to the effective cessation of financial markets from the perspective of a foreign investor.

There is clear evidence that China has been moving in a similar direction with some commentators seeing the ongoing stimulus efforts as the start of a process to implement a more independent monetary policy and insulate China's domestic economy from overseas investors and policymakers, though this would entail ceding control over the exchange rate. If China were to undertake further aggressive actions against Taiwan, the shift towards autarky at least from the perspective of the US and her allies would be greatly accelerated and foreign investors would most likely suffer a similar fate as in the case of Russia.

This worst-case scenario would effectively kill off EM equities as an asset class through the specific impact on the Chinese and Taiwanese markets in addition to a more general spike up in risk premia, although the growing proportion of funds invested in EM-ex China would mitigate some of the damage.

Now, returning to the reverse convergence theme, what of the scenarios where developed bond and/or equity markets come under sustained pressure? This could happen in four ways:

• First US Treasury bond yields which have been under pressure for the past three years could push well beyond their recent support levels to 5% or higher due to rising concerns about the fiscal deficit. In this scenario the USD should be pushed lower as happened to the GBP during the Liz Truss debacle. EM debt would most likely perform well in terms of spreads but yields of both EM USD and to a lesser extent local currency debt would still rise. It's more difficult to predict the response from EM equities but my best guess would be an initial fall in line with their US peers, followed by a sharp recovery, as cash was redeployed towards the perceived beneficiaries of a weaker USD, as well as the inevitable actions by the Fed in yield control.

• Second, if US Treasury bond yields push well beyond their recent support levels to 5% or higher due to evidence that the US economy is continuing to strengthen accompanied by rising inflationary pressures. This scenario unlike the fiscal concerns would most likely send the USD higher and EM currencies lower, with both EM USD denominated debt and especially local currency denominated debt performing poorly whilst EM equities would most likely struggle in absolute terms and almost certainly underperform relative to the US market.

• Third, if the US equity market were to topple over through the weight of its own momentum as happened in 2000, would the falling USD which is usually positive for emerging market equities, outweigh EM equities customary status as collateral damage, exemplified by the sharp falls following the dot com bust? I suspect that it would and again as in the preceding case, the Fed's subsequent actions would be conducive to a massive rally in EM equities but from a lower base – 2001 having been the buying opportunity of a lifetime.

• There is a fourth scenario propagated by some of what I would term the more extreme members of the bullish EM community, namely that the actions of the US and its allies in effectively confiscating the USD holdings of Russia has sent out a warning to other countries to diversify into non-US assets. This partly accounts for the strength of gold and to a lesser extent crypto over the course of this year. However, those states and other actors who wish to diversify are frustrated by the limited alternative options available to them, including the renminbi, which very few outside the 'axis of authoritarianism' perceive as a credible store of value, even though it's increasingly used as a medium of exchange.

The EM versus DM equity call is therefore no longer so straightforward as it has been for the past fourteen years, but this doesn't necessarily imply that absolute returns in EM are likely to improve, as there is the potential for a big sell-off in response to developments in the US and/or China.

My biggest conviction is that volatility in financial markets is likely to increase by a significant amount over the medium and possibly even the short term. I also believe that we have reached peak indexation in terms of returns, so taking these two factors together, a much more active approach is necessary and that will be the subject of my next note.

For the time being I'm therefore reasonably happy to hide out in short dated sovereign bonds and gradually reduce holdings of US equity index funds as the market reaches new highs and wait to deploy cash as opportunities present themselves.