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Asset markets experienced a bumper performance year-to-date, rolling back much of the sharp sell-off of late 2018. While bonds have delivered decent returns this year, risk assets (credit, commodities and equities) did extraordinarily well. Developed market (DM) equities led the charge, gaining 12.5% in Q1 in net total return terms (ex-US 10.5%). Emerging market (EM) equities performed strongly too, but lagged DM somewhat, with a return of 9.9% or 6.5% excluding China.
The overall market rally doubtlessly owed much to the Fed’s unexpected pivot on rates. This was less a change in its reaction function as some have touted than an acknowledgement of a changed reality. Data releases had taken a sharp turn for the worse in Q4 and markets accordingly first priced out the chance of rate hikes in 2019 in December 2018 and in February 2019 began pricing as many as two rate cuts. However, the differential performance between DM and EM may appear odd in light of some developments which occurred over the same period. First, while the economic data stream in both had been disappointing in Q1, it generated much deeper negative surprises in DM than EM. Second, the improvement in risk sentiment that accompanied the more dovish Fed stance would normally be expected to create stronger demand for the higher-beta asset, all else equal.
So why the lagging performance of EM? It could have to do with initial market positioning, but evidence suggests a significant market underweight in EM equities in late 2018 and proportionately greater flows into EM than into DM markets. It could also reflect the scale of the sell-off in Q4, which was much sharper for DM at 18% vs. a mere 9% for EM. However, EM equities were sliding for most of 2018 and from their February peak, they had declined a full 25%.
Hence, the lagging EM performance either implies a significant potential for catch-up or else, markets are correct in pricing more limited upside potential for EM than for DM. Indeed, the three issues that dominate the outlook for 2019 could be most consequential for EM: 1) the risk of higher US rates and tighter financial conditions, 2) slowing growth, in particular in the US and China and 3) rising trade tensions. There has been respite on all three fronts recently: both the US and China have held off from further policy tightening or reignited stimulative policies (in the case of China also on fiscal policy); activity indicators have taken a turn for the positive, with PMIs in particular returning to expansionary levels, and hopes for a breakthrough in trade talks have been rising (albeit admittedly on thin evidence other than continued delay in imposing punitive measures).
That said, these changes are still tentative and the absence of a full resolution of these concerns weighs more heavily on EM than on DM. Emerging markets are more indebted and thus more sensitive to rate changes than DM, they are less domestic-consumption driven/more export-oriented and hence more dependent on foreign demand growth. Finally, their economies are more open and thus more vulnerable to disruptions to world trade than DM.
This interpretation is also consistent with the return patterns within EM, where above-average returns were concentrated in China (and Russia) in Q1. MSCI China returned 18% during Q1 (China A Inclusion Index 30%), significantly outpacing all other countries in the asset class. China, of course, is the economy at the centre of investor focus, where the growth slowdown and trade conflict are most pronounced. Any easing on these fronts due to stimulative measures and progress in negotiations thus benefits it disproportionately.
*The publication reflects asset performance up to March 29, 2019, and macro events and data releases up to April 5, 2019, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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