In the second quarter of 2023, emerging market (EM) equities had mixed and lackluster performance. The MSCI EM Index only gained 0.9%, significantly underperforming the MSCI World Index of developed market (DM) equities, which increased by 6.8% during the same period. So far this year, the MSCI EM Index has gained 4.9%, compared to a 15.1% gain for the MSCI World Index. The underperformance of EM equities can mainly be attributed to the poor performance of China’s market, which makes up about one-third of the overall EM benchmark. China lost 9.7% in the second quarter and 5.5% year to date. However, if we exclude China, EM equities rose by 6.1% in the quarter and 14.7% year to date.
China’s underperformance is due to ongoing geopolitical tensions with the US and evidence of a slower-than-expected reopening recovery. On the other hand, DM and EM excluding China benefited from the belief that the global economy could achieve a soft landing as inflation pressures ease. This perception was supported by the softening of global commodity prices, with the Bloomberg Commodity Index down nearly 4% for the quarter and 10% year to date. Despite several rounds of production cuts by OPEC+, oil prices also trended down, aligning with the overall decline in the Bloomberg Commodity Index.
While key DM central banks like the Federal Reserve, European Central Bank, and Bank of England have pushed “higher-for-longer” messages on interest rates in response to above-target core inflation rates, the Bank of Japan maintained its accommodative policies, and the People’s Bank of China made modest rate cuts to support the economy. These policy divergences have been a challenge for Asian currencies, with the Japanese yen and Chinese yuan down 10.8% and 4.2% year to date, respectively. On the other hand, key Latin American currencies like the Brazilian real and Mexican peso have risen 10.1% and 15.2% year to date, supported by high real interest rates. Mexico is also benefiting from nearshoring by corporations reducing their exposure to China.
In the second quarter, EM Latin America was the best-performing region with a gain of 14.0%, followed by the EM region of Europe, the Middle East, and Africa (EMEA) with a gain of 2.7%. EM Asia was the poorest-performing region, posting a decline of 0.8%, as China’s weakness masked solid returns in India, South Korea, and Taiwan. EM sector returns were also mixed, with the Energy sector performing the best due to production cutbacks by OPEC+. The Financial and Information Technology sectors also had solid gains. However, the EM Information Technology sector lagged its DM counterpart due to China’s poor performance and concerns about tech restrictions.
The Consumer Discretionary and Communication Services sectors were the weakest in the quarter, posting declines of -6.4% and -6.8%, respectively. These sectors, along with Consumer Staples, Health Care, Materials, and Real Estate, were weighed down by China’s poor performance. It is worth noting that the EM Value Index has outperformed the EM Growth Index by 3.3% year to date, in contrast to DM markets where Value has underperformed Growth by 9.1%.
EM valuations remain low, with the MSCI EM Index trading at a 21% discount compared to the MSCI World Index of DM stocks. Despite the recent disappointment in China’s recovery, China has the potential to adjust its economic policy at the upcoming Politburo meeting in July. Additionally, it faces no inflation constraints in providing further economic stimulus. With many other EM central banks likely to cut interest rates soon, we believe leading EM nations are in a favorable business cycle position compared to key DM nations focused on combating inflation.
It is worth noting that global investors appear to be significantly underweight EM equities in global benchmarks. For instance, data from J.P. Morgan shows that as of mid-2023, global equity funds had only allocated 5.9% of their $25.8 trillion fund universe to EM. In comparison, the MSCI All Country World Index currently has a 10.7% weight toward EM. This suggests that investors in the J.P. Morgan global fund universe are underweight EM by approximately $1.2 trillion. Despite ongoing geopolitical risks and the potential for global equity markets to be impacted if major DM economies enter a recession, we maintain a cautiously optimistic view on EM equities.