Emerging market (EM) equities posted a solid gain of 5.0% in the second quarter, marking the fifth consecutive quarter of gains. EM equities benefited from ample evidence that the global economy continues to recover from the pandemic shock. Also, as U.S. 10-year Treasury yields dipped back below 1.5% in the quarter, a basket of MSCI EM currencies gained 1.2% against the U.S. dollar, led by a 9.2% gain in the Brazilian real. However, the MSCI EM Index in the second quarter trailed the 7.7% gain in the MSCI World Index of developed market (DM) equities. For the year to date, that left EM equities up only 7.4% compared to a gain of 13.0% for DM equities.
The relative underperformance of EM equities in a global bull market appears to reflect numerous cross currents. First, America’s exceptionally aggressive fiscal policy makes it likely that the U.S. will grow faster than China in 2021, especially since China is taking advantage of its early recovery to rein in credit growth. Second, many key EM nations have lagged behind the U.S. and Europe in vaccinations. As a result, many have struggled with episodes of renewed COVID-19 outbreaks and mobility restrictions to cope with more contagious new variants. That said, China made notable progress in the second quarter, with nearly 90% of its population having received at least one vaccine dose by mid-year.
A third important cross-current has been the emergence of inflationary pressures around the world as recovering demand has collided with disrupted supply chains and rising commodity prices. Although the main DM central banks including the Fed, the European Central Bank, and the Bank of Japan have taken a very patient approach toward adjusting monetary policy, a number of EM central banks have taken a more orthodox and hawkish approach toward signs of inflation. For example, Turkey has seen rates go up by 1,075 basis points this cycle, Brazil by 225 basis points, Russia by 75 basis points, and most recently Mexico with a surprise 25 basis point rate hike. Although rates in Turkey have probably peaked, further tightening seems likely in Brazil, Russia, and Mexico, as well as in a number of Eastern European economies. That said, EM nations that have been struggling with the Delta variant like India, Indonesia, the Philippines, and Thailand seem likely to maintain accommodative policy for longer.
Reflecting the buoyancy of the global economy, commodity prices like Brent crude and the CRB Raw Industrials Index rose by 17% and 7%, respectively, in the second quarter, and by 44% and 19% for the year to date. Against that backdrop, highly cyclical sectors like Energy, Materials, and Industrials were some of the top-performing sectors in the second quarter, although they were eclipsed by a robust 14% gain in the Health Care sector. The only EM sector to decline in the second quarter was Real Estate, which felt the brunt of China’s credit squeeze. But sectors like Information Technology, Consumer Discretionary, Utilities, and Communication Services also lagged the market, with China’s credit policy and anti-monopoly initiatives dampening prospects for some growth stocks.
Many of the cross-currents just mentioned were also reflected in the regional pattern of returns. Commodity-sensitive EM regions like Latin America and Europe, the Middle East, and Africa (EMEA) outperformed in the second quarter with gains of 15.1% and 11.3% respectively. In contrast, EM Asia lagged with a gain of only 3.8% in the second quarter. China’s credit restraint and anti-monopoly initiatives dampened returns in Asia, as did the ongoing pandemic issues mentioned above.
Despite the uneven pattern of the global economic recovery, we remain optimistic that the most likely scenario for the world economy is for a multi-year expansion that will be constructive for EM equities. And while markets debate whether recent inflationary pressures are transitory or sticky, corporate earnings in both EM and DM seem likely to track the multi-year economic expansion and provide a positive tailwind to equity markets. The good news for EM investors is that EM valuations remain attractively valued versus U.S. equities, with a Shiller PE ratio for EM of 16.6x at the end of June compared to 33.1x for the U.S.